wiley cfa 2017 level i - study guide vol 3

Wiley Study Guide for 2017 Level I CFA Exam Review

Complete Set

Thousands of candidates from more than 100 countries have relied on these Study Guides to pass the CFA ®Exam. Covering every Leaming Outcome Statement (LOS) on the exam, these review materials are an invaluable tool for anyone who wants a deep-dive review of all the concepts, formulas, and topics required to pass.

Wiley study materials are produced by expert CFA charterholders, CFA Institute members, and investment professionals from around the globe. For more information, contact us at [email protected].

Wiley Study Guide for 2017 Level I CFA Exam Review

WILEY

Copyright© 2017 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Prior to 2014, the material was published by Elan Guides.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online athttp://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fibless for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-ondemand. H this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material athttp://booksupport.wiley.com. For more information about Wtley products, visit www.wiley.com.

Required CFA Institute® disclaimer:

"CFA ®and Chartered Financial Analyst® are trademarks owned by CFA Institute. CFA Institute (formerly the Association for Investment Management and Research) does not endorse, promote, review or warrant the accuracy of the products or services offered by John Wiley & Sons, Inc."

Certain materials contained within this text are the copyrighted property of CFA Institute. The following is the copyright disclosure for these materials:

"Copyright 2016, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved."

These materials may not be copied without written permission from the author. The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics. Your assistance in pursuing potential violators of this law is greatly appreciated.

Disclaimer: John Wiley & Sons, Inc.'s study materials should be used in conjunction with the original readings as set forth by CFA Institute in the 2017 CFA Level I Curriculum. The information contained in this book covers topics contained in the readings referenced by CFA Institute and is believed to be accurate. However, their accuracy cannot be guaranteed.

ISBN 978-1-119-34692-0

Contents

About the Authors

Wiley Study Guide for 2017 Level I CFA Exam Volume 1: Ethics & Quantitative Methods

Study Session 1: Ethical and Professional Standards

Reading 1: Ethics and Trust in the Investment Profession Lesson 1: Ethics and Trust in the Investment Profession

xiii

Reading 2: Code of Ethics and Standards of Professional Conduct 11 Lesson 1: Code of Ethics and Standards of Professional Conduct 11

Reading 3: Guidance for Standards I-VII 17 Lesson 1: Standard I: Professionalism 17 Lesson 2: Standard II: Integrity of Capital Markets 43 Lesson 3: Standard Ill: Duties to Clients 53 Lesson 4: Standard IV: Duties to Employers 77 Lesson 5: Standard V: Investment Analysis, Recommendations, and Actions 91 Lesson 6: Standard VI: Conflicts of Interest 104 Lesson 7: Standard VII: Responsibilities as a CFA Institute Member or CFA Candidate 114

Reading 4: Introduction to the Global Investment Performance Standards (GIPS) 123 Lesson 1: Introduction to the Global Investment Performance Standards (GIPS) 123

Reading 5: The GIPS Standards 125 Lesson 1: Global Investment Performance Standards (GIPS) 125

Study Session 2: Quantitative Methods: Basic Concepts

Reading 6: The Time Value of Money Lesson 1: Introduction, Interest Rates, Future Value, and Present Value Lesson 2: Stated Annual Interest Rates, Compounding Frequency, Effective

Annual Rates, and Illustrations ofTVM Problems

Reading 7: Discounted Cash Flow Applications Lesson 1: Net Present Value and Internal Rate of Return Lesson 2: Portfolio Return Measurement Lesson 3: Money Market Yields

©2017Wiley

131 131

142

151 151 156 158

CONTENTS

0

Reading 8: Statistical Concepts and Market Returns 165 Lesson 1: Fundamental Concepts, Frequency Distributions, and the Graphical

Presentation ofData 165 Lesson 2: Measures of Central Tendency, Other Measures of Location (Quantiles),

and Measures ofDispersion 169 Lesson 3: Symmetry, Skewness, and Kurtosis in Return Distributions and

Arithmetic versus Geometric Means 181

Reading 9: Probability Concepts 185 Lesson 1: Probability, Expected Value, and Variance 185 Lesson 2: Covariance and Correlation and Calculating Portfolio Expected Return

and Variance 198 Lesson 3:Topics in Probability: Bayes' Formula and Counting Rules 204

Study Session 3: Quantitative Methods: Application

Reading 10: Common Probability Distributions 213 Lesson 1: Discrete Random Variables, the Discrete Uniform Distribution, and

the Binomial Distribution 213 Lesson 2: Continuous Random Variables, the Continuous Uniform Distribution,

the Normal Distribution, and the Lognormal Distribution 221 Lesson 3: Monte Carlo Simulation 236

Reading 11 : Sampling and Estimation 239 Lesson 1: Sampling, Sampling Error, and the Distribution of the Sample Mean 239 Lesson 2: Point and Interval Estimates of the Population Mean, Student's

!-distribution, Sample Size, and Biases 243

Reading 12: Hypothesis Testing 251 Lesson 1: Introduction to Hypothesis Testing 251 Lesson 2: Hypothesis Tests Concerning the Mean 261 Lesson 3: Hypothesis Tests Concerning the Variance and Nonparametric Inference 271

Reading 13: Technical Analysis 279 Lesson 1: Technical Analysis: Definition and Scope 279 Lesson 2: Technical Analysis Tools: Charts, Trend, and Chart Patterns 280 Lesson 3: Technical Analysis Tools: Technical Indicators and Cycles 294 Lesson 4: Elliott Wave Theory and lntermarket Analysis 302

Appendix: Probability Tables 305

Wiley Study Guide for 2017 Level I CFA Exam Volume 2: Economics

Study Session 4: Microeconomics and Macroeconomics

Reading 14: Topics in Demand and Supply Analysis Lesson 1: Demand Analysis: The Consumer Lesson 2: Supply Analysis: The Firm 16

© 2017Wiley

Reading 15:The Firm and Market Structures Lesson 1: Market Structure 1: Perfect Competition Lesson 2: Market Structure 2: Monopoly Lesson 3: Market Structure 3: Monopolistic Competition Lesson 4: Market Structure 4: Oligopoly Lesson 5: Identification of Market Structure

Reading 16: Aggregate Output, Prices, and Economic Growth Lesson 1: Aggregate Output and Income Lesson 2: Aggregate Demand, Aggregate Supply, and Equilibrium:

Part 1 (Fundamental Relationships) Lesson 3: Aggregate Demand, Aggregate Supply, and Equilibrium:

Part 2 (IS-LM Analysis and the AD Curve) Lesson 4: Aggregate Demand, Aggregate Supply, and Equilibrium:

Part 3 (Macroeconomic Changes and Equilibrium) Lesson 5: Economic Growth and Sustainability

Reading 17: Understanding Business Cycles Lesson 1: The Business Cycle Lesson 2: Unemployment, Inflation, and Economic Indicators

Study Session 5: Economics: Monetary and Fiscal Policy, International Trade, and Currency Exchange Rates

37 37 43 49 52 57

61 61

70

72

84 94

99 99

108

Reading 18: Monetary and Fiscal Policy 123 Lesson 1: Monetary Policy (Part I) 123 Lesson 2: Monetary Policy (Part II) 129 Lesson 3: Fiscal Policy 134

Reading 19: International Trade and Capital Flows 143 Lesson 1: Basic Terminology: Absolute and Comparative Advantage 143 Lesson 2: Trade and Capital Flows: Restrictions and Agreements 149 Lesson 3: The Balance of Payments and Trade Organizations 156

Reading 20: Currency Exchange Rates 161 Lesson 1: The Foreign Exchange Market 161 Lesson 2: Currency Exchange Rate Calculations: Part 1 166 Lesson 3: Currency Exchange Rate Calculations: Part 2 171 Lesson 4: Exchange Rate Regimes and the Impact of Exchange Rates on Trade

and Capital Flows 176

Wiley Study Guide for 2017 Level I CFA Exam Volume 3: Financial Reporting & Analysis

Study Session 6: Financial Reporting and Analysis: An Introduction

Reading 21: Financial Statement Analysis: An Introduction Lesson 1: Financial Statement Analysis: An Introduction

©2017Wiley

CONTENTS

CONTENTS

Reading 22: Financial Reporting Mechanics Lesson 1: Classification of Business Activities and Financial Statement

Elements and Accounts Lesson 2: Accounting Equations Lesson 3: The Accounting Process Lesson 4: Accruals, Valuation Adjustments, Accounting Systems, and

Using Financial Statements in Security Analysis

Reading 23 : Financial Reporting Standards Lesson 1: Financial Reporting Standards

Study Session 7: Financial Reporting and Analysis: Income Statements, Balance Sheets, and Cash Flow Statements

Reading 24: Understanding Income Statements Lesson 1: Income Statement: Components and Format Lesson 2: Revenue and Expense Recognition Lesson 3: Non-Recurring Items, Non-Operating Items Lesson 4: Earnings per Share, Analysis of the Income Statement, and

Comprehensive Income Lesson 5: Analysis of the Income Statement and Comprehensive Income

Reading 25: Understanding Balance Sheets Lesson 1: Balance Sheet: Components and Format Lesson 2: Assets and Liabilities: Current versus Non-Current Lesson 3: Equity Lesson 4: Analysis of the Balance Sheet

Reading 26: Understanding Cash Flow Statements Lesson 1: The Cash Flow Statement: Components and Format Lesson 2: The Cash Flow Statement: Linkages and Preparation Lesson 3: Cash Flow Statement Analysis

Reading 27: Financial Analysis Techniques Lesson 1: Analytical Tools and Techniques Lesson 2: Common Ratios Used in Financial Analysis Lesson 3: DuPont Analysis, Equity Analysis, Credit Analysis, and Business and

Geographic Segments

Study Session 8: Financial Reporting and Analysis: Inventories, Long-lived Assets, Income Taxes, and Non-current Liabilities

Reading 28: Inventories Lesson 1: Cost of Inventories and Inventory Valuation Methods Lesson 2: The LIFO Method and Inventory Method Changes Lesson 3: Inventory Adjustments and Evaluation of Inventory Management

11 13

19

23 23

41 41 44 60

62 70

75 75 78 86 88

91 91 95

104

109 109 115

132

147 147 156 165

© 2017Wiley

Reading 29: Long-Lived Assets Lesson 1: Acquisition of Long-Lived Assets: Property, Plant, and Equipment

and Intangible Assets Lesson 2: Depreciation and Amortization of Long-Lived Assets, and the

Revaluation Model Lesson 3: Impairment of Assets, Derecognition of Assets, Presentation and

Disclosures, and Investment Property Lesson 4: Leasing

Reading 30: Income Taxes Lesson 1: Key Definitions and Calculating the Tax Base of Assets and Liabilities Lesson 2: Creation of Deferred Tax Assets and Liabilities, Related Calculations,

and Changes in Deferred Taxes Lesson 3: Recognition and Measurement of Current and Deferred Tax and

Presentation and Disclosure

Reading 31 : Non-Current (Long-Term) Liabilities Lesson 1: Bonds Payable Lesson 2: Leases Lesson 3: Pensions and Other Post-Employment Benefits and Evaluating Solvency

Study Session 9: Financial Reporting and Analysis: Financial Reporting Quality and Financial Statement Analysis

177

177

194

205 215

227 227

232

243

251 251 259 269

Reading 32: Financial Reporting Quality 277 Lesson 1: Conceptual Overview and Quality Spectrum of Financial Reports 277 Lesson 2: Context for Assessing Financial Reporting Quality 282 Lesson 3: Detection ofFinancial Reporting Quality Issues 285

Reading 33: Financial Statement Analysis: Applications 297 Lesson 1: Evaluating Past Financial Performance and Projecting Future Performance 297 Lesson 2: Assessing Credit Risk and Screening for Potential Equity Investments 300 Lesson 3: Analyst Adjustments to Reported Financials 303

Wiley Study Guide for 2017 Level I CFA Exam Volume 4: Corporate Finance, Portfolio Management, & Equity

Study Session 1 O: Corporate Finance: Corporate Governance, Capital Budgeting, and Cost of Capital

Reading 34: Corporate Governance and ESG: An Introduction Lesson 1: Corporate Governance and ESG: An Introduction

Reading 35: Capital Budgeting Lesson 1: Capital Budgeting

Reading 36: Cost of Capital

©2017Wiley

Lesson 1: Cost of Capital Lesson 2: Costs of the Different Sources of Capital Lesson 3: Topics in Cost of Capital Estimation

17 17

31 31 35 40

CONTENTS

CONTENTS

Study Session 11: Corporate Finance: Leverage, Dividends and Share Repurchases, and Working Capital Management

Reading 37: Measures of Leverage Lesson 1: Measures of Leverage

Reading 38: Dividends and Share Repurchases: Basics Lesson 1: Dividends Lesson 2: Share Repurchases

Reading 39: Working Capital Management Lesson 1: Working Capital Management

Study Session 12: Portfolio Management

Reading 40: Portfolio Management: An Overview Lesson 1: Portfolio Management: An Overview

Reading 41 : Risk Management: An Introduction Lesson 1: The Risk Management Process and Risk Governance Lesson 2: Identification of Risks and Measuring and Modifying Risks

Reading 42: Portfolio Risk and Return: Part I Lesson 1: Investment Characteristics of Assets Lesson 2: Risk Aversion, Portfolio Selection, and Portfolio Risk Lesson 3: Efficient Frontier and Investor's Optimal Portfolio

Reading 43: Portfolio Risk and Return: Part II Lesson 1: Capital Market Theory Lesson 2: Pricing of Risk and Computation of Expected Return Lesson 3: The Capital Asset Pricing Model

Reading 44: Basics of Portfolio Planning and Construction Lesson 1: Portfolio Planning Lesson 2: Portfolio Construction

Study Session 13: Equity: Market Organization, Market Indices, and Market Efficiency

S1 S1

6S 6S 71

79 79

101 101

109 109 116

12S 12S 13S 146

1S3 1S3 1S7 161

173 173 176

Reading 45: Market Organization and Structure 181 Lesson 1: The Functions of the Financial System, Assets, Contracts, Financial

Intermediaries, and Positions 181 Lesson 2: Orders, Primary and Secondary Security Markets, and Market Structures 192 Lesson 3: Well-Functioning Financial Systems and Market Regulation 197

Reading 46: Security Market Indices 199 Lesson 1: Index Definition, Calculations, Construction, and Management 199 Lesson 2: Uses of Market Indices and Types of Indices 212

Reading 47: Market Efficiency 217 Lesson 1: The Concept of Market Efficiency and Forms of Market Efficiency 217 Lesson 2: Market Pricing Anomalies and Behavioral Finance 221

0 ©2017Wiley

Study Session 14: Equity Analysis and Valuation

Reading 48: Overview of Equity Securities Lesson 1: Overview of Equity Securities

Reading 49: Introduction to Industry and Company Analysis Lesson 1: Introduction to Industry and Company Analysis

Reading 50: Equity Valuation: Concepts and Basic Tools Lesson 1: Introduction Lesson 2: Present Value Models Lesson 3: Multiplier Models and Asset-Based Valuation

Wiley Study Guide for 2017 Level I CFA Exam Volume S: Fixed Income, Derivatives, & Alternative Investments

Study Session 15: Fixed Income: Basic Concepts

Reading 51 : Fixed Income Securities: Defining Elements Lesson 1: Overview of a Fixed-Income Security Lesson 2: Legal, Regulatory and Tax Considerations Lesson 3: Structure of a Bond's Cash Flows Lesson 4: Bonds with Contingency Provisions

Reading 52: Fixed-Income Markets: Issuance, Trading, and Funding Lesson 1: Overview of Global Fixed-Income Markets Lesson 2: Primary and Secondary Bond Markets Lesson 3: Issuers ofBonds Lesson 4: Short-Term Funding Alternatives Available to Banks

Reading 53: Introduction to Fixed-Income Valuation Lesson 1: Bond Prices and the Time Value of Money Lesson 2: Prices and Yields (Part I): Conventions for Quotes and Calculations Lesson 3: Prices and Yields (Part II): Matrix Pricing and Yield Measures for Bonds Lesson 4: Prices and Yields (Part Ill) : The Maturity Structure of Interest Rates

and Calculating Spot Rates and Forward Rates Lesson 5: Yield Spreads

Reading 54: Introduction to Asset-Backed Securities Lesson 1: Introduction, the Benefits of Securitization and the Securitization Process Lesson 2: Residential Mortgage Loans and Residential Mortgage-Backed

Securities (RMBS) Lesson 3: Commercial Mortgage-Backed Securities (CMBS) and Non-Mortgage

Asset-Backed Securities (ABS) Lesson 4: Collateralized Debt Obligations (CDOs)

Study Session 16: Fixed Income: Analysis of Risk

Reading 55: Understanding Fixed-Income Risk and Return Lesson 1: Sources of Risk

©2017Wiley

Lesson 2: Interest Rate Risk on Fixed-Rate Bonds Lesson 3: Yield Volatility, Interest Rate Risk and the Investment Horizon,

and Credit and Liquidity Risk

227 227

237 237

255 255 256 265

11 12 18

25 25 27 29 33

37 37 43 49

61 68

71 71

75

91 94

101 101 107

128

CONTENTS

0

CONTENTS

Reading 56: Fundamentals of Credit Analysis 133 Lesson 1: Credit Risk, Capital Structure, Seniority Ranking, and Recovery Rates 133 Lesson 2: Rating Agencies, Credit Ratings, and Their Role in Debt Markets 136 Lesson 3: Traditional Credit Analysis 138 Lesson 4: Credit Risk versus Return :Yields and Spreads 145 Lesson 5: Special Considerations of High Yield, Sovereign, and Municipal Credit Analysis 147

Study Session 17: Derivatives

Reading 57: Derivative Markets and Instruments Lesson 1: Dervative Markets, Forward Commitments, and Contingent Claims Lesson 2: Benefits and Criticisms of Derivatives, and Arbitrage

Reading 58: Basics of Derivative Pricing and Valuation Lesson 1: Fundamental Concepts and Price versus Value Lesson 2: Forward Contracts Lesson 3: Futures Contracts Lesson 4: Swap Contracts Lesson 5: Option Contracts Part 1: European Option Pricing Lesson 6: Option Contracts Part 2: Binomial Option Pricing Lesson 7: Option Contracts Part 3: American Option Pricing

Reading 59: Risk Management Applications of Option Strategies Lesson 1: Option Strategies

Study Session 18 Alternative Investments

155 155 158

161 161 165 176 180 185 202 209

213 213

Reading 60: Introduction to Alternative Investments 221 Lesson 1: Alternative Investments 221 Lesson 2: Major Types of Alternative Investments, Part I: Hedge Funds 223 Lesson 3: Major Types of Alternative Investments, Part II : Private Equity, Real Estate,

Infrastructure, and Commodities 229 Lesson 4: Risk Management 243

© 2017Wiley

ABOUT THE AUTHORS

Wiley's Study Guides are written by a team of highly qualified CFA charterholders and leading CFA instructors from around the globe. Our team of CFA experts work collaboratively to produce the best study materials for CFA candidates available today.

Wiley's expert team of contributing authors and instructors is led by Content Director Basil Shajani, CFA. Basil founded online education start-up Elan Guides in 2009 to help address CFA candidates' need for better study materials. As lead writer, lecturer, and curriculum developer, Basil 's unique ability to break down complex topics helped the company grow organically to be a leading global provider ofCFA Exam prep materials. In January 2014, Elan Guides was acquired by John Wiley & Sons, Inc., where Basil continues his work as Director of CFA Content. Basil graduated magna cum laude from the Wharton School of Business at the University of Pennsylvania with majors in finance and legal studies. He went on to obtain his CFA charter in 2006, passing all three levels on the first attempt. Prior to Elan Guides, Basil ran his own private wealth management business. He is a past president of the Pakistani CFA Society.

There are many more expert CFA charterholders who contribute to the creation of Wiley materials. We are thankful for their invaluable expertise and diligent work. To learn more about Wiley's team of subject matter experts, please visit: www.efficientlearning.com/cfa/why-wiley/.

©2017Wiley

STUDY SESSION 6: FINANCIAL REPORTING AND

ANALYSIS: AN INTRODUCTION

© 2017Wiley

FINANCIAL STATEMENT ANALYSIS: AN INTRODUCTION

READING 21: FINANCIAL STATEMENT ANALYSIS: AN INTRODUCTION

LESSON 1: FINANCIAL STATEMENT ANALYSIS: AN INTRODUCTION

LOS 21a: Describe the roles of financial reporting and financial statement analysis. Vol 3, pp 6-11

Role of financial statement reporting: To provide information about a company's financial performance, financial position, and changes in financial position.

Role of financial statement analysis: To assess a company's past performance and evaluate its future prospects using financial reports along with other relevant company information. Assessments are performed prior to making an investing decision, offering any credit facilities, or making other economic decisions related to the company.

A company's performance can be examined through profitability (ability to generate profits from core business activities) and cash flow (ability to generate cash receipts in excess of cash payments) measures. A forecast of the expected amount of future cash flows is important in determining the company's ability to meet its obligations.

Liquidity refers to a company's ability to meet its short-term obligations. Solvency refers to a company 's ability to meet its long-term obligations.

LOS 2lb: Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, and statement of cash flows) in evaluating a company's performance and financial position. Vol 3, pp 11- 24

Companies prepare financial statements to report their operating performance to investors and creditors.

Statement of Comprehensive Income (or Income Statement plus Statement of Other Comprehensive Income)

The income statement is also known as the statement of operations or profit and loss statement. It provides operating information relating to a company's business activities over a period of time (the accounting period). The income statement presents revenues earned by a company and corresponding costs. The difference between a company's total revenue and total costs equals net income.

I Net income =Revenue - Expenses I

Income statements are useful in evaluating a company's profitability and therefore are an important source of information for financial statement analysis.

©2017Wiley

Income statements and other comprehensive income (and the statement of comprehensive income) are discussed in more detail in Reading 24.

FINANCIAL STATEMENT ANALYSIS: AN INTROOUCTION

Wewilllearnmore about baJance sheets, cash flow statements, and the statement of changes in owners' equity in later readings.

Balance Sheet

Balance sheets, also known as statements of financial position, present a company's assets, liabilities, and equity at a point in time. The interrelationships between these three components of the balance sheet is presented in the basic accounting equation:

I Assets = Liabilities+ Owners' equity I

Assets are the productive resources that a company owns. Liabilities are amounts that the company owes other entities. Owners' equity represents shareholders' residual claim on the company's assets after deducting liabilities.

I Owners' equity = Assets - Liabilities I

The information contained in balance sheets is used to assess a company's financial position and to evaluate its ability to meet short-term and long-term obligations.

Cash Flow Statement

A cash flow statement reports the various sources of cash receipts and cash payments. The statement classifies the sources and uses of cash into operating, investing, and financing activities.

Operating activities refer to the day-to-day core business activities of a company. Investing activities relate to the acquisition or disposal of long-term assets. Financing activities relate to the injection or repayment of capital.

Cash flow statements reflect a company's ability to generate cash from its core business activities. It is desirable that a company generates most of its cash from operating activities, as opposed to investing and financing activities. A company's sources and uses of cash provide valuable insight into its liquidity and solvency levels and its financial flexibility (ability to react and adapt to financial adversities and investment opportunities).

Statement of Changes in Owners' Eqnity

This statement reports any changes in owners' investment in the business. It is useful in understanding changes in the financial position of a company.

©2017Wiley


LOS 21c: Describe the importance of financial statement notes and supplementary information-including disclosures of accounting policies, methods, and estimates-and management's commentary. Vol 3, pp 24-27

Financial Notes and Supplementary Information

Financial notes are an important part of financial statements because they provide detailed explanatory information about the following:

Accounting policies, methods, and estimates Business acquisitions and disposals Commitments and contingencies Legal proceedings Subsequent events Related-party transactions Business and geographic segments Financial instruments and risks arising from them

Footnotes contain important details about the accounting methods, estimates, and assumptions that have been used by the company in preparing its financial statements. For example, information about the choice of revenue recognition method used and assumptions made to calculate depreciation expense are typically found in the footnotes. The availability of such information facilitates comparisons between companies that prepare their financial statements in accordance with different accounting standards (IFRS vs. U.S. GAAP). Note that financial statement footnotes are also audited.

Management's Discussion and Analysis (MD&A)

The management discussion and analysis section (required under U.S. GAAP) highlights important trends and events that affect a company's liquidity, capital resources, and operations. Management also discusses prospects for the upcoming year with respect to inflation, future goals, material events, and uncertainties. The section must also discuss critical accounting policies that require management to make subjective judgments and have a material impact on the financial statements. Although it contains important information, analysts should bear in mind that the MD&A section is not audited.

IFRS is in the process of finalizing a framework to provide guidance relating to items that should be discussed in management commentary. These items include:

The nature of the business Management objectives and strategies The company's significant resources, risks, and relationships Results of operations Critical performance measures

©2017Wiley 0


LOS 2ld: Describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls. Vol 3, pp 27-30

The financial statements presented in a company's annual report must be audited. They must be examined by an independent accounting firm (or audit practitioner) which then states its opinion on the financial statements. Audits are required by contractual arrangement, law, or regulation.

Objective of audits: Under International Standards for Auditing, objectives of an auditor are:

I. To obtain reasonable assurance about whether the financial statements as a whole are free from material ntisstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting frame-work; and

2. To report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor's findings. 1

Types of Audit Opinions An unqualified opinion states that the financial statements have been presented fairly in accordance with applicable accounting standards. A qualified opinion states that the financial statements have been presented fairly, but do contain exception(s) to the accounting standards. The audit report provides further details and explanations relating to the exception(s). An adverse opinion states that the financial statements have not been presented fairly and significantly deviate from acceptable accounting standards. A disclaimer of opinion is issued when the auditor, for whatever reason, is not able to issue an opinion on the financial statements.

Internal controls: The internal control system of a company seeks to ensure the reliability of processes used by the company in preparing its financial statements. In the United States, management is responsible for the effectiveness of internal control, to evaluate the effectiveness of internal control, to support the evaluation, and to provide a report on internal control.

LOS 21e: Identify and describe information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information. Vol 3, pp 31-32

Interim reports are prepared either sentiannually or quarterly. They contain the four financial statements and footnotes, but are not audited.

Proxy statements are distributed to shareholders when there are matters that require a shareholder vote. They provide information about management and director compensation, company stock performance, and potential conflicts of interest between management, the board of directors, and shareholders.

1 - See the International Auditing and Assurance Standards Board (lAASB) Handbook of International Quality Control, Auditing, Review, Other Assurance, and Related Services Pronouncements .

© 2017Wiley

FINANCIAL STATEMENT ANALYSIS: AN INTROOUCTION

Press releases, in addition to a company's website and conference calls, provide current information about the company. External sources provide information about the economy, the industry that the company operates in, and the company's competitors. Such information is useful as it allows the analyst to place the company's performance in perspective. Examples of external sources include trade journals and government agencies.

LOS 21f: Describe the steps in the financial statement analysis framework. Vol 3, pp 31-35

A generic framework for financial statement analysis involves the following steps:

1. Define the purpose and context of the analysis ln cases where the task is well-defined, the purpose is governed by institutional norms. However, there are also analytical tasks that require the analyst's discretion in defining the purpose. The definition of the purpose determines the approach, tools, data sources, and the format used to present results. ln this prelintinary stage, the analyst is also required to define the context of the analysis, which requires understanding the audience, the time frame, and the resources available for completion of the task.

2. Collect data The analyst acquires the necessary information to answer the questions that were defined in the previous stage. For instance, a task with the purpose of analyzing the historical performance of a company could be carried out by understanding the financial statements alone. However, a more thorough analysis that requires understanding a company' s financial performance and position relative to the industry would require collecting industry data as well.

3. Process data The financial information collected is converted into ratios, growth rates, commonsize financial statements, charts, and regressions.

4. Analyze/interpret the processed data The data is interpreted and a recommendation is reached.

5. Develop and communicate conclusions An appropriate format for the presentation of analysis is determined. The presentation format is sometimes determined by regulatory authorities or professional standards.

6. Follow up Financial statement analysis does not end with the preparation of a recommendation report. When equity analysis is performed or a credit rating is assigned, periodic reviews are required to determine whether previously drawn conclusions remain valid.

See Table 1-1.

©2017Wiley 0


Table 1-1: Financial Statement Analysis Framework'

Phase

I. Articulate the purpose and context of the analysis

2. Collect data

3. Process data

4. Analyze/interpret the processed data

5. Develop and communicate conclusions and recommendations (e.g., with an analysis report)

6. Follow up

Sources oflnformation

The nature of the analyst's function, such as evaluating an equity or debt investment or issuing a credit rating Communication with client or supervisor on needs and concerns Institutional guidelines related to developing specific work product

Financial statements, other financial data, questionnaires, and industry/economic data Discussions with management, suppliers, customers, and competitors Company site visits (e.g. , to production facilities or retail stores)

Data from the previous phase

Input data as well as processed data

Analytical results and previous reports Institutional guidelines for published reports

Information gathered by periodically repeating above steps as necessary to determine whether changes to holdings or recommendations are necessary

Output

Statement of the purpose or objective of analysis A list (written or unwritten) of specific questions to be answered by the analyst Nature and content of report to be provided Timetable and budgeted resources for completion

Organized financial statements Financial data tables Completed questionnaires, if applicable

Adjusted financial statements Common-size statements Ratios and graphs Forecasts

Analytical results

Analytical report answering questions posed in phase 1 Recommendation regarding the purpose of the analysis, such as whether to make an investment or grant credit

Updated reports and recommendations

2 - Components of this framework have been adapted from van Greuning and Bratanovic (2003, p. 300) and from Bcnninga and Sarig (1 997, pp. 134-156).

© 2017Wiley

READING 22: FINANCIAL REPORTING MECHANICS

LESSON 1: CLASSIFICATION OF BUSINESS ACTIVITIES AND FINANCIAL STATEMENT ELEMENTS AND ACCOUNTS

LOS 22a: Describe how business activities are classified for financial reporting purposes. Vol 3, pp 42-43

Business activities are classified into three categories for financial reporting purposes:

Operating Activities

FINANCIAL REPORTING MECHANICS

These are related to the day-to-day business activities of a company. Typical activities that fall into this category are:

Sales of goods and services to customers. Costs associated with the provision of goods and services. Income tax expenses. Investments in working capital to support the firm's ordinary business.

Investing Activities These are related to the acquisition and disposal of long-term assets. Examples of transactions that fall into this category include:

Acquisition or disposal of fixed assets like property, plant, and equipment (PP&E). Purchase or sale of other corporations' equity and debt securities.

Financing Activities These are related to raising and repaying capital. Examples of financing activities include:

Issuance or repurchase of common or preferred stock. Issuance or redemption of debt. Dividend payments on common and preferred stock.

The nature of a firm's operations dictates where certain transactions fall within these classifications. For example, interest received on an investment in a debt instrument by a music store is classified as an investing activity, but interest received by a bank is classified as an operating activity. (See Table 1-1.) The sale of an oven by an oven manufacturer is an operating activity, whereas the sale of an oven by a restaurant is an investing activity.

Table 1-1: Typical Business Activities and Financial Statement Elements Affected1

Type Business Activity Elements Affected

Operating activities

Investing activities

Financing activities

• Sale of goods and services to customers • Cost of providing the goods and services • Income tax expense • Holding short-term assets or incurring short-term

liabilities directly related to operating activities

• Purchase or sale of assets such as property, plant, and equipment

• Purchase or sale of other entities ' equity and debt securities

• Issuance or repurchase of the company's own preferred or common stock

• Issuance or repayment of debt • Payment of distributions (i.e., dividends to preferred

or common stock holders)

I - Exhibit I, Volume 3, CFA Program Curriculum 201 7.

©2017Wiley

Revenue Expenses Expenses Assets, liabilities

Assets

Assets

Owners' equity Liabilities

Owners ' equity


Each of the items that make up the elementsofthe balance sheet (assets, liabilities, and owners' equity) is discussed in detail in Reading 25.

LOS 22b: Explain the relationship of financial statement elements and accounts, and classify accounts into the financial statement elements. Vol 3, pp 43-46

There are five financial statement elements:

Assets Liabilities Owners' equity or shareholders' equity Revenues Expenses

An increase or a decrease in any of these elements is recorded in a specific account. For example, accounts receivable is an account that falls under the financial element of assets.

Financial statements present condensed information regarding financial statement elements and accounts. The actual accounts used in a company's accounting system are listed in a chart of accounts.

Classification of Accounts into Financial Statement Elements

Assets are a company's economic resources. They include:

Current assets:

Cash and cash equivalents. Accounts receivable, trade receivables. Prepaid expenses. Inventory.

Noncurrent assets:

Property, plant, and equipment. Investment property. Intangible assets (patents, trademarks, licenses, copyrights, and goodwill). Financial assets, trading securities, and investment securities. Investments accounted for by the equity method.

Sometimes contra accounts are used to reduce the balance of certain assets. Common contra asset accounts include allowance for bad debts (offset against accounts receivable) and accumulated depreciation (offset against PP&E).

Liabilities are creditors' claims on a company's economic resources. They include:

Accounts payable and trade payables. Financial liabilities such as notes payable. Deferred tax liabilities. Long-term debt. Unearned revenue.

Owners' equity represents owners' residual claim on a company's resources. It includes:

Capital in the form of common and preferred stock. Additional paid-in capital. Retained earnings. Other comprehensive income.

©2017Wiley


Revenues represent the flow of economic resources into the company and include:

Sales. Gains. Investment income.

Expenses represent the flow of economic resources out of the company, and include:

Cost of goods sold. Selling, general, and administrative expenses. Depreciation and amortization expenses. Interest expense. Tax expense. Losses.

For presentation purposes, assets are categorized as current and noncurrent assets.

Noncurrent assets are expected to benefit the company over an extended period of time (usually over one year).

Current assets are expected to be used by the company or converted into cash in the short term (less than one year). Current assets include:

Inventories: Unsold products on hand (also called inventory stock). Trade receivables: Amounts customers owe the company for products that have been sold. Cash on hand and at the bank.

LESSON 2: ACCOUNTING EQUATIONS

LOS 22c: Explain the accounting equation in its basic and expanded forms. Vol 3, pp 46-51

The basic accounting equation is:

I Assets= Liabilities+ Owners' equity I Owners' equity is the residual claim of the owners on a company's assets after all liabilities have been paid off.

I Owners' equity = Assets - Liabilities I Owners' equity can be further divided into its two components:

Owners' equity= Contributed capital+ Ending retained earnings

Ending retained earnings are calculated as:

Ending retained earnings= Beginning retained earnings+ Net income - Dividends declared

The equation for ending retained earnings can also be stated as:

Ending retained earnings = Beginning retained earnings+ Revenue - Expenses

- Dividends declared

©2017Wiley

Each of the items that make up the elements of the income statement (revenues and expenses) is discussed in detail in Reading 24.


Therefore, the basic accounting equation can be expanded into the following forms:

Assets= Liabilities+ Contributed capital+ Ending retained earnings

and:

Assets= Liabilities+ Contributed capital+ Beginning retained earnings

+ Revenue - Expenses - Dividends declared

Example2-1

An analyst has the following information regarding XYZ Company:

Net income

Beginning retained earnings

Dividends declared

Calculate ending retained earnings for 2008.

Solution

(Amounts in millions)

$225

$1 ,250

$75

Ending retained earnings= Beginning retained earnings+ Net income - Dividends declared

Ending retained earnings= $1,250 + $225 - $75 = $1,400 million

Example2-2

An analyst has the following information regarding ROB Company:

(Amounts in millions)

Revenue earned during the year

Beginning retained earnings

Expenses incurred during the year

Dividends declared for the year

Liabilities

Contributed capital

Calculate ROB's total assets at the end of 2008.

Solution

Step 1:

$350

$90

$280

$25

$120

$75

Ending retained earnings = Beginning retained earnings + Revenues - Expenses - Dividends declared

Ending retained earnings= $90 + $350 - $280 - $25 = $135 million

Step 2:

Assets = Liabilities + Contributed capital + Ending retained earnings

Assets= $120 + $75 + $135 = $330 million

© 2017Wiley


LESSON 3: THE ACCOUNTING PROCESS

LOS 22d: Describe the process of recording business transactions using an accounting system based on the accounting equation. Vol 3, pp 51-65

LOS 22f: Describe the relationships among the income statement, balance sheet, statement of cash flows, and statement of owners' equity. Vol 3, pp 65-68

The process of recording business transactions is based on double-entry accounting (i.e .• every transaction affects at least two accounts). If an asset account increases, either a liability or an equity/capital account will also increase, or another asset account will decrease to keep the accounting equation in balance.

Example 3-1 illustrates the process of recording business transactions in an accounting system.

Example 3-1: Recording Transactions in an Accounting System

Sunshine Inc. operates a shoe store. It purchases each pair of shoes for $100 and sells each pair for $150. Sunshine's activities for the month of June are listed as follows.

No. Date Business Activity

June 1 Sunshine Inc. started business by depositing $100,000 in its bank account.

2 June 3 Purchased a shop for $55,000 in cash.

3 June 7 Purchased stock of 25 pairs of shoes for $2,500 on credit from suppliers.

4 June 10 Purchased 230 more pairs of shoes on credit for $23,000.

June 13 Sold 50 pairs of shoes for $7,500. Received $3,000 in cash and the rest was treated as a receivable.

6 June 15 Sold 20 pairs of shoes for $3,000 cash.

7 June 18 Received $2,500 cash for shoes sold on June 13.

June 23 Paid $2,000 cash for shoes bought on June 7. Paid $16,500 cash for shoes bought on June IO. The balance amount is payable after a month.

9 June 30 Received $2,000 for shoes that were sold on credit on June 13.

IO June 30 Paid utility bills amounting to $950. Wages amounting to $2,000 were also paid.

©2017Wiley

Remembering the basic accounting equation and understanding which direction the financialelemenLS will move given a certain transaction are EXTREMELY important to do well on the exam.


Analysis of Transactions

An increase in expenses reduces net income, retained earnings, and owners' equity.

@

I. Cash and owners' equity increase by $100,000. (Assets and owners' equity increase.)

2. Premises asset account increases by $55,000 and cash decreases by $55,000. (Noncurrent assets increase and current assets decrease.)

3. Inventory increases by $2,500 and accounts payable increase by $2,500. (Current assets and current liabilities increase.)

4. Inventory and accounts payable increase by $23,000. (Current assets and current liabilities increase.)

5. Cash increases by $3,000 and accounts receivable increase by $4,500. Inventory decreases by the cost of 50 units , $5,000. (Net current assets increase by $2,500.)

Revenue increases by $7,500 and cost of goods sold (COGS) increases by $5,000. The excess of revenues over COGS contributes to net income and increases owners' equity through retained earnings. (Owners' equity increases by $2,500.)

6. Cash increases by $3,000 while inventory decreases by $2,000. (Net assets increase by $1,000.)

Sales revenue increases by $3,000 and COGS increases by $2,000. (Owners ' equity increases by $1 ,000.)

7. Cash increases by $2,500, and accounts receivable fall by $2,500. (Total current assets stay at the same level.)

8. Cash and accounts payable fall by $18,500. (Current assets and current liabilities decrease.)

9. Cash increases by $2,000 and accounts receivable decrease by $2,000. (Total current assets stay at the same level.)

10. Cash falls and expenses (utilities) increase by the same amount ($950). Cash falls and expenses (wages) increase by the same amount ($2,000). (Owners ' equity falls by $2,950.)

© 2017Wiley


The following worksheet presents the effects of each transaction.

Assets Liabilities Owners' Equity

Date Cash Accounts Inventory Shop = Accounts Owners' Revenue Expenses Receivable Premises Payable Capital

June 1 100,000 = 100,000

June3 (55,000) 55,000 =

June7 2,500 = 2,500

June 10 23,000 = 23,000

June 13 3,000 4,500 (5,000) = 7,500 5,000

June 15 3,000 (2,000) = 3,000 2,000

June 18 2,500 (2,500) =

June 23 (2,000) = (2,000)

(16,500) = (16,500)

June 30 2,000 (2,000) =

June30 (2,950) = 2,950

Total 34,050 + 0 + 18,500 + 55,000 = 7,000 + 100,000 + 10,500 - 9,950

A final income statement, balance sheet, cash flow statement, and statement of changes in owners' equity can now be prepared reflecting all transactions and adjustments.

Sunshine Inc. Income Statement I Noti« that inoomo

statements are For the month ended June 30, 2008 prepared for a

$ period of time.

10,500 Sales revenue

COGS (7,000)

Gross Profit 3,500

Expenses

Wages 2,000

Utility expenses 950 ---

Total Expenses 2,950

Net Income 550

©2017Wiley


Balance sheets are prepared as of a particular point in time.

Cash flow statements are also prepared fora period of time.

Sunshine Inc. Balance Sheet As of June 30, 2008

Assets

Cash

Accounts receivable

Inventory

Shop premises

Total Assets

Liabilities and Owners' Equity

Liabilities

Accounts payable

Total liabilities

Owners' Equity Contributed capital

Retained earnings (net income of June 2008)

Total Liabilities and Owners' Equity

Sunshine Inc. Statement of Cash Flows For the month ended Jone 30, 2008

Cash Flow from Operating Activities

Cash received from customers

Cash paid to suppliers

Cash paid for operating expenses

Net Operating Cash Flow

Cash Flow from Investing Activities

Purchase of shop premises

Net Investing Cash Flow

Cash Flow from Financing Activities

Capital contributed by owners

Net Financing Cash Flow

Net Increase in Cash

Cash balance at June 1, 2008

Cash Balance at June 30, 2008

$

34,050

0

18,500

55,000

107,550

7,000 ---

7,000

100,000

550 ---100,550 ---107,550

$

10,500

(18,500)

(2,950) ----

(10,950)

(55,000) ----

(55,000)

100,000 ----

100,000

34,050

0 ----34,050

©2017Wiley

Sunshine Inc. Statement of Changes in Owners' Equity For the month ended June 30, 2008

Contributed Capital

$

Retained Earnings

$


Total

$

Balance at June 1, 2007

Net income (loss)

Balance at June 30, 2008

100,000 0 100,000

550 550

100,000 550 100,550

Financial statements are prepared from the data provided by the accounting system. Accounts that fall under revenues and expenses become a part of the income statement. Accounts that fall under assets, liabilities, and owners ' equity are used to construct the balance sheet.

Now we will use the example of Sunshine Inc. to illustrate the relationships between different financial statements.

©2017Wiley


Balance Sheet Income Statement

$ Assets $

Sales revenue 10,500 Cash ,. 34,050 COGS (7 ,000) Accounts receivable 0 Gross Profit 3,500 Inventory 18,500

Shop 55 000 Expenses Total Assets 107,550 Wages 2,000

Utility expenses ~ Liabilities and Owners' Equity 2 Total Expenses 2,950

---Liabilities Net Income

r~ Accounts payable 7,000

Total liabilities 7,000

Owners' Equity Cash Flow Statement dJ Contributed capital 100,000 Retained earnings (Net income of June 2008) ~ !-----+ 550 $

100,550 Cash Flow from Operating Activities

Total Liabilities and Owners' Equity 107,550 Cash received from customers 10,500 Cash paid to suppliers (18,500) Cash paid for expenses __Q,2lQl

dJ Net Operating Cash Flow (10,950)

Cash Flow from Investing Activities Purchase of shop (55,000) Net Investing Cash Flow (55,000)

Cash Flow from Financing Activities Capital contributed from owner 100,000 Net Financing Cash Flow - f+l00,000

Net Increase in Cash 34,050 Cash balance at June 1, 2008 0 Cash Balance at June 30, 2008 1 34,050

Statement of Owners' Equity 0 Contributed Capital Retained Earnings Total

$ $ $ Balance at June 1, 2007 100,000 0 100,000

Net income (loss) 550 55v Balance at June 30, 2008 100,000 550 100,550

I. The income statement shows a net income of $550 for June 2008, which, in the absence of dividends, increases retained earnings by $550. This increase is reflected on the statement of shareholders ' equity and on the balance sheet under owners ' equity.

2. The cash flow statement shows that cash increases by $34,050 over the period. The increase in cash is also seen on the balance sheet under current assets.

3. The owners ' capital contribution of $100,000 is listed under cash flow from financing activities. The balance sheet shows this contribution under owners ' equity.

@ ©2017Wiley


LESSON 4: ACCRUALS, VALUATION ADJUSTMENTS, ACCOUNTING SYSTEMS, AND USING FINANCIAL STATEMENTS IN SECURITY ANALYSIS

LOS 22e: Describe the need for accruals and valuation adjustments in preparing financial statements. Vol 3, pp 69-71

Accrual Entries

Accrual accounting is based on the principle that revenues should be recognized when earned and expenses should be recognized when incurred, irrespective of when the actual exchange of cash occurs. The timing difference between cash movements and recognition of revenues or expenses explains the need for accrual entries. When cash is transferred in the period that the related revenue/expense is recognized, there is no need for accrual entries. There are four types of accrual entries:

I. Unearned (or deferred) revenue arises when a company receives a cash payment before it provides a good or a service to the customer. Because the company still has to provide the good/service, unearned revenue is recognized as a liability. Unearned revenue is subsequently earned once the good is sold or the service is provided.

Example 4-1: Unearned Revenue

On September 30, Nicky receives $1,000 from a tenant as rent for October.

Originating Entry September 30: Cash (asset) i $1,000

Unearned rental income (liability) i $1,000

I Assets i =Liabilities i + Owners' equity I

Adjusting Entry October 31: Unearned rental income (liability) .J. $1,000

Rent revenue (income/equity) i $1,000

!Assets =Liabilities.J. +Owners' equity i i

2. Unbilled or accrued revenue arises when a company provides a good or service before receiving the cash payment. Because the company is owed money, accrued revenue is recognized as an asset.

©2017Wiley

Rental income increases net income, retained earnings, and owners' equity.


Insurance expense reduces net income, retained earnings, and owners' equity.

Example 4-2: Accrued Revenue

Jelena Inc. provides services worth $5,500 to another company during the month of May. The payment will be received a month later.

Originating Entry May 31: Accounts receivable (asset) 1' $5,500

Revenue (income) 1' $5,500

I Assets 1' =Liabilities+ Owners' equity 1' I

Adjusting Entry June 30 (when payment is received): Cash (asset) 1' $5,500

Accounts receivable (asset) 1' $5,500

I Assets 1' .J, = Liabilities+ Owners' equity I

3. Prepaid expenses arise when a company makes a cash payment before recognizing the expense. Expenses that have been paid in advance are an asset of the company.

Example 4-3: Prepaid Expenses

Aztec Inc. purchased an insurance policy for $1,200 for the year 2008. It made the entire payment on January 1, 2008.

Originating Entry January 1: Insurance prepaid (asset) 1' $1 ,200

Cash (asset) .J, $1 ,200

I Assets I .J, = Liabilities+Owners' equity I

Every month, the company will recognize insurance expense of $100 and reduce the prepaid asset by the same amount. By the end of the year, the entire insurance prepaid asset will be written off and a total insurance expense of$1,200 will have been recognized.

Adjusting Entry Every month: Insurance expense 1' $100 (owners ' equity .J,)

Insurance prepaid (asset) .J, $ 100

I Assets .J, = Liabilities+ Owners' equity .J, I

© 2017Wiley


4. Accrued expenses arise when a company recognizes an expense in its books before actually making a payment for it. Because the company owes a payment, the accrued expense is treated as a liability.

Example 4-4: Accrued Expenses

Prudent Inc. owes its employees $2,250 for work performed during the month of March. Wages are actually paid in May.

Originating Entry March: Wages expense 1' $2,500 (owners ' equity .J,)

Wages payable (liability) I $2,500

I Assets= Liabilities 1' + Owners' equity .J, I Adjusting Entry May: Wages payable (liability) .J, $2,500

Cash (asset) .J, $2,500

I Assets .J, = Liabilitied + Owners' equity I

Exhibit 4-1: Accruals2

Cash Movement prior to Accounting Recognition

Unearned (deferred) Revenue

Originating Entry Record cash receipt and establish a

liabili ty Adjusting Entry

Reduce the liab ility and recognize revenue

Prepaid Expense

Originating Entry Record cash payment and establish an

asset Adjusting Entry

Reduce the asset and recognize the expense

2 -Exhibit 10, Volume 3, CFA Program Curriculum 2017.

© 2017Wiley

Cash movement in the same period as

accounting recogn ition

j Settled transaction-

no accrual entry needed

Cash Movement after Accounting Recognition

Unbilled (accrued) Revenue

Originating En try Record revenue and estab li sh an asset

Adjusting [ntry When billing occurs, reduce unbil led

revenue and increase accounts receivable. When cash is collected,

e liminate the receivab le.

Accrued Expenses

Originating Entry Establish a liability and record an expense

Adjusting Entry Reduce the liabil ity as cash is paid


Accountants use the tenns debit and credit to describe changes in accounts resulting from a transaction. For the purposes of the CFA exam, you do not need to be able to classify accounting entries in terms of debits and credits.

@

Valuation Adjustments

Most assets and liabilities are recorded on the balance sheet at their historical cost. However, accounting standards require certain items to be shown on the balance sheet at their current market values. The upward or downward adjustments to the values of these assets and liabilities are known as valuation adjustments. For example, if there is a decline in the value of an asset, the new decreased value is recorded on the balance sheet and the amount of the decrease in value is recognized as a loss either on the income statement or in other comprehensive income.

LOS 22g: Describe the flow of information in an accounting system. Vol 3, pg 72

In an accounting system, information flows through four stages:

Journal entries: The amount and relevant accounts affected by transactions are chronologically recorded in journals. At the end of the accounting period, adjusting entries are made to journal entries to account for accruals that had not been recorded earlier. General ledger: The general ledger sorts all the entries posted in journals into accounts. For example, the general ledger contains an inventory account where all inventory-related journal entries are listed. Trial balance: An initial trial balance lists all the ending balances of general ledger accounts. Adjustments to record accruals and prepayments that had not been considered in constructing the initial trial balance are made in the adjusted trial balance. Financial statements: The account balances in the adjusted trial balance are used to construct financial statements.

LOS 22h: Describe the use of the results of the accounting process in security analysis. Vol 3, pp 73-74

Financial statements provide the basis for equity and credit analysis. However, analysts must make adjustments to reflect the effects of items not reported in the statements. Analysts must also evaluate management's assumptions regarding accruals and valuations. Information related to most of these assumptions can be found in the significant accounting policies footnote and in the management discussion and analysis (MD&A) section of the annual report.

Since assumptions within the accounting process are, to an extent, in the hands of management, financial statements can be manipulated to misrepresent a company's true financial performance. Companies can recognize fictitious assets and liabilities on the financial statements in an attempt to cover aggressive accounting practices or even fraud. For example, if management wanted to inflate reported revenue, it would also recognize a fictitious asset (a receivable) to balance the accounting equation. On the other hand, if the company has received cash but management does not want to recognize the related revenue, it could create a fictitious liability to keep the accounting equation in balance. We will study incentives for accounting manipulation and keys to detecting such fraudulent practices in later readings.

©2017~1ey

FINANCIAL REPORTING STANDARDS

READING 23: FINANCIAL REPORTING STANDARDS

LESSON 1: FINANCIAL REPORTING STANDARDS

LOS 23a: Describe the objective of financial statements and the importance of financial reporting standards in security analysis and valuation. Vol 3, pp 10~102

The International Accounting Standards Board's (IASB 's) objective of general purpose financial reporting, as stated in its Conceptual Framework for Financial Reporting 2010 (Conceptual Framework 2010), is to "provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit."1

The process of developing financial reporting standards is quite complicated. Some transactions do not necessarily have one correct treatment, so standards are set with the aim of achieving some degree of consistency in the treatment of these transactions. Therefore, the IASB and U.S. Financial Accounting Standards Board (FASB) have developed similar frameworks for financial reporting.

Financial statements are not designed only to facilitate asset valuation; they provide information to a host of users (e.g. , creditors, employees, and customers). At the same time, they do provide important inputs for the asset-valuation process. For analysts, it is extremely important to understand how and when judgments and subjective estimates affect the financial statements. Such an understanding is important to evaluate the wisdom of business decisions, and to make comparisons between companies.

LOS 23b: Describe roles and desirable attributes of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards, and describe the role of the International Organization of Securities Commissions. Vol 3, pp 103-111

The Role of Standard-Setting Bodies and Regulatory Authorities

Standard-setting bodies, such as the IASB and FASB, are private sector organizations of accountants and auditors that develop financial reporting rules, regulations, and accounting standards. Regulatory authorities, like the Securities and Exchange Commission (SEC) in the United States, and Financial Standards Authority (FSA) in the United Kingdom have legal authority to enforce financial reporting requirements, and can overrule private sector standard-setting bodies. Standard-setting bodies have no authority unless their standards are recognized by regulatory authorities.

I - Conceptual Framework (2010) Chapter 8, 082. Under U.S. GAAP, the identical statement appears in Concept Statement 8, Chapter I, 082.

©2017Wiley


Standard-Setting Bodies

International Accounting Standards Board (IASB)

The IASB is the independent standard-setting body of the IFRS Foundation, which is an independent, not-for-profit private sector organization. The principal objectives of the IFRS Foundation are to develop and promote the use and adoption of a single set of highquality financial standards; to ensure the standards result in transparent, comparable, and decision-useful information while taking into account the needs of a range of sizes and types of entities in diverse economic settings; and to promote the convergence of national accounting standards and IFRS.

The IFRS Interpretations Committee is responsible for reviewing accounting issues that arise in the application of IFRS and are not specifically addressed by IFRS. The IFRS Advisory Council provides advice to the IASB on agenda decisions and priorities among other items.

Financial Accounting Standards Board (FASB)

The FASB issues new and revised standards with the aim of improving standards of financial reporting so that information provided to users is useful for decision-making. The FASB standards are contained in the FASB Accounting Standard Codification™ (Codification). The Codification is the source of all authoritative U.S. generally accepted accounting principles (U.S. GAAP) for nongovernmental entities. U.S. GAAP is officially recognized as authoritative by the Securities and Exchange Commission (SEC). However, the SEC retains the authority to establish standards.

Desirable Attributes of an Accounting Standards Board The responsibilities of all parties involved in the standard-setting process should be clearly defined. All parties involved in the standard-setting process should observe high professional and ethical standards, including standards of confidentiality. The organization should have adequate authority, resources, and competencies. There should be clear and consistent processes to guide the organization and formation of standards. There should be a well-articulated framework with a clearly stated objective to guide the board. The board should seek and consider input from all stakeholders. However, it should operate independently and make decisions that are in line with the stated objective of the framework. The board should not succumb to pressure from external forces. Final decisions should be in public interest, and should lead to a set of high-quality standards that will be recognized and adopted by regulatory authorities.

© 2017Wiley

Regulatory Authorities

Regulatory authorities are governmental entities that have the legal authority to enforce the financial reporting requirements set forth by the standard-setting bodies, and to exert control over entities that participate in capital markets within their jurisdiction.

FINANCIAL REPORTING STAN DAROS

IOSCO (International Organization of Securities Commission) is not a regulatory authority, but its members regulate a large portion of the world's financial capital markets. IOSCO sets out three core objectives of securities regulation: 2

1. Protection of investors. 2. Ensuring that markets are fair, efficient, and transparent. 3. Reducing systematic risk.

IOSCO's principles are grouped into nine categories, including principles for regulators, for enforcement, for issuers, and for auditors. With increasing globalization, the organization aims to assist its members in the development of internationally comparable financial reporting standards. Further, it assists in attaining uniform regulation and crossborder cooperation in combating violations of securities and derivatives laws. Finally, it provides guidance regarding the use of Self-Regulatory Organizations (SROs) in overseeing their respective areas of expertise.

The U.S. Securities and Exchange Commission

Any company issuing securities in the United States, or otherwise involved in U.S. capital markets is subject to the rules of the SEC. The SEC requires companies to subntit numerous forms periodically. These filings, which are available on the SEC website (www.sec.gov), are a key source of information for analysis of listed firms. The forms most relevant for financial analysts include:

All companies that issue new securities are required to file a Securities Offerings Registration Statement. Required information includes disclosures about the securities, the relationship of these new securities to the issuer's other capital securities, the information typically provided in annual filings, recent audited financial statements, and risk factors involved in the business. Forms 10-K, 20-F, and 40-F must be filed annually. In these forms, companies provide a comprehensive business overview and disclose important financial data (historical overview of performance, management discussion & analysis (MD&A) report, and audited financial statements). This information is also available in a company's annual report. However, annual reports are prepared for shareholders and are not required by the SEC. Forms 10-Q and 6-K: U.S. companies file form 10-Q quarterly while non-U.S. firms file form 6-K semiannually. These submissions require unaudited financial statements, MD&A reports, and disclosure of any nonrecurring events.

2 - Objectives and Principles of Securities Regulation, IOSCO, June 2010.

©2017Wiley


Proxy Statement/ Form DEF-14A: The SEC requires that shareholders of a company be sent a proxy statement before any shareholder meeting. A proxy is an authorization from a shareholder granting another party the right to vote on her behalf. The following information is contained in a proxy statement:

o Details of proposals that require shareholder vote. o Ownership stakes of senior management and principal owners. o Director biographies. o Executive compensation disclosures.

The proxy statement that is filed with the SEC is known as Form DEF- I 4A.

Form 8-K: This form must be filed for significant events that include the acquisition or disposal of corporate assets, changes in management or corporate governance, changes in securities and trading markets, and matters related to accountants and financial statements. Form 144: This form is filed to announce a possible sale of restricted securities or the sale of securities held by affiliates of the issuer. Forms 3, 4, 5, and 11-K: These forms are used to examine purchases and sales of securities by management, directors, employees, and other affiliates of the company.

Capital Market Regulation in Europe: Each country in the European Union (EU) regulates its own capital market. However, certain regulations have been adopted at the EU level to achieve some consistency in securities regulation among the different member states. In 2002 the EU agreed that from January I, 2005 , listed companies would prepare their consolidated accounts in accordance with the IFRS.

LOS 23c: Describe the status of global convergence of accounting standards and ongoing barriers to developing one universally accepted set of financial reporting standards. Vol 3, pp 112-115

The IASB and FASB, along with other standard setters, are working to achieve convergence of financial reporting standards.

In 2002, the IASB and FASB both acknowledged their commitment to develop high quality, compatible accounting standards that can be used for both domestic as well as cross-border financial reporting. In 2004, both the boards agreed to align their conceptual frameworks and to work together in developing any significant accounting standards in the future. In the short term they aimed to remove selected differences, while in the medium term they agreed to issue joint standards in areas where significant improvements were required. In 2009, both the boards affirmed their commitment to achieve convergence in selected major projects by June 2011. This date was later revised to late 2011.

Convergence between U.S. GAAP and IFRS is underway. Time and again, the SEC has reiterated its commitment to global accounting standards and is looking into incorporating IFRS into the financial reporting system for U.S. issuers. Convergence between IFRS and other local GAAP (e.g., Japanese GAAP) is also underway.

© 2017Wiley

However, the move toward developing one set of universally accepted financial reporting standards is impeded by two factors:

Standard-setting bodies and regulators have different opinions regarding appropriate accounting treatments due to differences in institutional, regulatory, business, and cultural environments. Powerful lobbyists and business groups, whose reported financial performance would be affected adversely by changes in reporting standards, exert pressure against the adoption of unfavorable standards.

LOS 23d: Describe the International Accounting Standards Board's conceptual framework, including the objective and qualitative characteristics of financial statements, required reporting elements, and constraints and assumptions in preparing financial statements. Vol 3, pp 116-128


The IASB uses the Conceptual Framework for Financial Reporting 2010 (Conceptual Framework 2010) to develop reporting standards. The framework assists standard setters in developing and reviewing standards, assists preparers of financial statements in applying standards, helps auditors in fanning an opinion on financial statements, and aids users in interpreting financial statement information. Table 1-1 summarizes the current status of IFRS adoption in selected countries, while Figure 1-1 summarizes the Conceptual Framework 2010.

Table 1-1: International Adoption Status of IFRS in Selected Locations as of June 2010'

Europe

North America

The EU requires companies listed in EU countries to adopt IFRS beginning with their 2005 financial statements. Switzerland requires that Swiss multinational companies listed on the main board of the Swiss Exchange must choose either U.S. GAAP or IFRS. Some countries (for example, Georgia, Macedonia, Moldova, Serbia) use IFRS as adopted locally. Georgia, for example, uses the IFRS 2007 edition. Some countries (for example, Czech Republic, Finland, Germany, Ireland, Lithuania, Netherlands, Norway, and Poland) pennit some foreign companies listing on local exchanges to use other specified and/or well-recognised standards.

The U.S. SEC accepts IFRS for non-U.S. registrants and no longer requires a reconciliation to U.S. GAAP for filers using IFRS. The U.S. FASB is engaged in numerous projects with the IASB to achieve convergence of U.S. GAAP and IFRS. The U.S. SEC announced its intention to decide by 2011 whether to incorporate IFRS into financial reporting by U.S. issuers.

(Table continued on next page . .. )

3 - Sources: Based on data from www.iasb.org, www.sec.gov, www.iasplus.com, and www.pwc.com

©2017Wiley


Table 1-1: (continued)

Central and South America

In Canada, listed companies are required to use IFRS beginning January 1, 2011. The year ending December 31, 2010 is the last year of reporting under current Canadian GAAP. In November 2008, Mexico announced plans to move to IFRS in 2012. Most of the island nations off the southeast coast of North America require or permit the use of IFRS by listed companies.

Central America, Costa Rica, Honduras, and Panama require the use of IFRS. EI Salvador, Guatemala, and Nicaragua permit the use of IFRS. Brazil requires that listed companies and financial institutions use IFRS, starting with periods ending in 2010. Brazilian GAAP continues to converge to IFRS. Ecuador requires listed companies, other than financial institutions, to use IFRS beginning in 2010. Chile requires major listed companies to use IFRS for 2009 financial statements. Other companies are permitted to use IFRS. Venezuela permits listed companies to use IFRS. The expectation is that listed companies will be required to use IFRS by 2011. Peru and Uruguay require the use of IFRS as adopted locally. In Argentina, convergence of ARO GAAP to IFRS is in progress. Listed foreign companies are permitted to use their primary GAAP, including IFRS, but should also include a reconciliation to ARO GAAP. Bolivia is moving toward convergence with IFRS. In Colombia and Paraguay, the adoption of IFRS is in early stages of consideration.

Asia and Middle • Listed companies in a number of countries-including India, East Indonesia, and Thailand- report under local GAAP, and plans exist

to either converge with or transition to IFRS. Companies in China report under Chinese accounting standards (CAS). CAS are largely converged with IFRS and China's November 2009 proposed Roadmap targeted 2011 as the year for completion of convergence of IFRS and CAS. Financial institutions are required to prepare financial statements in accordance with IFRS in addition to their statements prepared using CAS. In Japan, some companies that meet certain criteria may use IFRS, otherwise companies report using Japanese GAAP. Japan has launched a joint project with the IASB to reduce differences between Japanese GAAP and IFRS. In Malaysia, domestic listed companies report using local GAAP and foreign companies listed on Malaysian exchanges are permitted to use IFRS. Malaysia plans to have full convergence with IFRS by January 2012. In Hong Kong, companies incorporated in Hong Kong normally report under Hong Kong FRS. These are largely converged with IFRS. Korea requires the use of IFRS beginning 2011. Early adoption was permitted from 2009.

©2017Wiley


Table 1-1: (continuetf)

Oceana

Africa

©2017Wiley

Listed companies are required to report under IFRS in a number of other countries, including Kyrgyz Republic, Lebanon, and Turkey. A number of countries, including Pakistan, Philippines, and Singapore, require use of IFRS as adopted locally. In Singapore, IFRS is permitted for use by companies that list on other exchanges that require IFRS or if permission is given by the Accounting and Corporate Regulatory Authority. In a number of countries, IFRS is required for some types of entities and permitted for others. For example, Armenia requires IFRS for financial organizations and permits its use for others, Azerbaijan requires IFRS for banks and state-owned public interest entities, Israel requires IFRS for domestic listed companies except for banking institutions, Kazakhstan requires IFRS for domestic listed companies, large business entities and public-interest entities, Saudi Arabia requires IFRS for all banks regulated by the Saudi Arabian Monetary Agency (central bank), and Uzbekistan requires IFRS for all commercial banks and permits IFRS for others. Vietnam requires IFRS for state-owned banks and permits IFRS for commercial banks; all other listed companies report under Vietnamese accounting standards. Some countries, including Afghanistan and Qatar, permit the use of IFRS.

Australia requires Australian reporting entities to use IFRS as adopted locally. Foreign companies listing on local exchanges are permitted to use IFRS or their primary GAAP. The Australian regulator may require additional information. New Zealand requires use of IFRS as adopted locally (NZ-IFRS).

Many African countries, including Botswana, Ghana, Kenya, Malawi, Mauritius, Namibia, South Africa, Swaziland, Tanzania, Uganda, Zambia, and Zimbabwe, require IFRS for listed companies. Morocco requires the use of IFRS for consolidated financial statements of bank and financial institutions and permits its use for others. Mozambique requires the use of IFRS for financial and lending institutions and for certain large entities. Use of IFRS is permitted by other entities beginning in 2010. Egypt requires the use of local GAAP, which is partially converged withIFRS. The Nigerian Federal executive Council approved January 1, 2012 as the effective date for convergence of accounting standards in Nigeria with IFRS. In some countries, financial statements are required to be prepared in accordance with the Organization for the Harmonization of Business Law in Africa accounting framework. These countries include Cameroon, Cote D' Ivoire, and Equatorial Guinea.


Figure 1-1: lFRS Framework for the Preparation and Presentation of Financial Reports4

*Material is an aspect of relevance.

Reporting Elements

Qualitative Characteristics

Objective

To Provide Financial Information Useful in Making

Decisions about Providing Resources to the Entity

Relevance* Faithful Representation

Performance o Income o Expenses o Capital Maintenance Adjustments o Past Cash Flows

Constraint

Comparability, Verifiability, Timeliness, Understandability

Financial Position o Assets o Liabilities o Equity

• Cost (cost/benefit considerations)

Underlying Assumption • Accrual Basis • Going Concern

4 - Exhibit 2, Vol 3, CFA Program Curriculum 201 7

© 2017Wiley

FINANCIAL REPORTING STAN DAROS

Objective of Financial Statements

Under the Conceptual Framework, the objective of general purpose financial reporting is to provide financial information that is useful in making decisions about providing resources to the entity to existing and potential providers of resources (e.g., investors, lenders, and creditors) to the entity.

Qualitative Characteristics

The Conceptual Framework identifies two fundamental qualitative characteristics that make financial information useful; relevance and faithful representation:

Relevance: The information presented in the financial statements should be useful in making forecasts (have predictive value) and/or be useful to evaluate past decisions or forecasts (have confirmatory value). Further, the criterion of materiality states that information should be timely and sufficiently detailed with no material omissions or misstatements of information that could make a difference to users' decisions.

Faithful Representation: This requires that the information presented is:

Complete (i.e., all the information necessary to understand the phenomenon is included); Neutral (i.e., information presented is free from any bias); and Free from error (i.e. , there are no errors of commission or omission in the description of the economic phenomenon). Further, an appropriate process is adhered to , without error, in order to arrive at the reported information.

The Conceptual Framework also identifies four supplementary qualitative characteristics that increase the usefulness of relevant and faithfully represented financial information. These are:

Comparability : The presentation of financial statements should be consistent over time and across firms to facilitate comparisons. Verifiability: Different knowledgeable and independent observers should be able to verify that the information presented faithfully represents the economic phenomena that it is supposed to represent. Timeliness: Information should be available to users in a timely manner. Understandability: Users with basic business and accounting knowledge, who are willing to make reasonable efforts to study the information presented, should be able to easily understand the information presented.

Constraints on Financial Statements

While it would be ideal for financial statements to exhibit all the desirable characteristics listed earlier, there are several constraints to achieving this goal:

There may be a tradeoff between certain desirable characteristics. For example, companies must estimate bad debts (amount of credit sales that the company will not be able to collect) when presenting financial information so that financial statements can be released in a timely manner. However, the fact estimated expenses must be included reduces the verifiability of the statements.

©2017Wiley


There is a cost of providing useful financial information. The benefits from information should exceed the costs of providing it. Intangible aspects (e.g., company reputation, brand name, customer loyalty, and corporate culture) cannot be quantified and reflected in financial statements. Unfortunately, nonquantifiable information is omitted from financial statements.

Reporting Elements

The elements of financial statements that are related to the measurement of financial position are:

Assets: Resources owned and controlled by a company from which it expects to realize future benefits. Liabilities: Obligations of a company that are expected to result in future outflow of resources. Equity: The residual claim of owners on assets of the company after subtracting all liabilities.

Elements related to the measurement of financial performance are:

Income: Increases in economic benefits in the form of inflows or enhancement of assets or reductions in liabilities that result in increases in equity (other than increases resulting from contributions by owners). Income includes revenues and gains. Revenue refers to income generated through ordinary activities of the business (e.g., sale of products). Gains may result from ordinary activities or other activities (e.g. , sale of surplus machinery). Expenses: Decreases in economic benefits in the form of outflows or depletion of assets or increases in liabilities that result in reductions in equity (other than reductions due to distributions to owners). Expenses include normal expenditures that occur in day-to-day business activities (e.g., wages) and losses.

Underlying Assumptions in Financial Statements

Two important assumptions that determine how financial statement elements are recognized and measured are:

Accrual basis accounting requires that transactions should be recorded on the financial statements (other than on the cash flow statement) when they actually occur, irrespective of when the related exchange of cash occurs. Going concern refers to the assumption that the company will continue operating for the foreseeable future. If this is not the case, fair representation would require all assets to be written down to their liquidation values. The value of a company's year-end stock of inventory would be higher if it were allowed to sell it over a normal period of time, compared to its value if the company were forced to liquidate it immediately.

© 2017Wiley


Recognition and Measurement of Financial Statement Elements

An element should be recognized on the financial statements if the future benefit from the item (flowing into or out of the firm) is probable, and if its value/cost can be estimated with reliability. The monetary value of the item recognized on the financial statements depends on the measurement base used. The following bases of measurement are typically used:

Historical cost: For an asset, historical cost refers to the amount that it was originally purchased for. For liabilities, it refers to the amount of proceeds that were received initially in exchange for the obligation. Amortized cost: Historical cost adjusted for amortization, depreciation, or depletion and/or impairment. Current cost: For an asset, current cost refers to the amount that the asset can be purchased for today. For liabilities, it refers to the total undiscounted amount of cash that would be required to settle the obligation today. Realizable (settlement) value: In reference to assets, realizable value refers to the amount that the asset can be sold for in an ordinary disposal today. For liabilities, it refers to the undiscounted amount of cash expected to be paid to settle the liability in the normal course of business. Present value: For assets, present value refers to the discounted value of future net cash flows expected from the asset. For liabilities, it refers to the present discounted value of future net cash outflows that are expected to be required to settle the liability. Fair value: This is mentioned in the Conceptual Framework, but not specifically defined. It refers to the amount that the asset can be exchanged for, or a liability can be settled for, in an arm's length transaction. Fair value may be based on market value or present value.

LOS 23e: Describe general requirements for financial statements under IFRS. Vol 3, pp 123-127

International Accounting Standard (IAS) No. I , Presentation of Financial Statements, specifies which financial statements are mandatory and how they must be presented. (See Table 1-2.)

Required Financial Statements Statement of financial position (balance sheet). Statement of comprehensive income (in a single statement or in two separate statements, i.e. , the income statement+ statement of comprehensive income). Statement of changes in equity. Statement of cash flows. Significant accounting policies and explanatory notes to facilitate the understanding of financial statements. In certain cases, a statement of financial position from earliest comparative period.

©2017Wiley


General Features of Financial Statements Fair presentation: This requires faithful representation of transactions, in compliance with the definitions and recognition criteria for reporting elements (assets, liabilities, equity, income, and expenses) set out in the Conceptual Framework. Going concern: Financial statements should be prepared on a going concern basis unless management has plans to liquidate the company. Accrual basis: All financial statements, except the cash flow statement, should be prepared on an accrual basis. Materiality and aggregation: Financial statements should be free from omissions and misrepresentations that could influence decisions taken by users. Similar items should be grouped and presented as a material class. Dissimilar items, unless immaterial, should be presented separately. No offsetting: Assets and liabilities and income and expenses should not be used to offset each other, unless a standard requires or allows it. Frequency of reporting: Financial statements must be prepared at least annually. Comparative information: Comparative amounts should be presented for prior periods unless a specific standard permits otherwise. Consistency: Items should be presented and classified in the same manner in every period.

Structure and Content Requirements Classified statement of financial position: Current and noncurrent assets and current and noncurrent liabilities should be shown separately on the balance sheet. Minimum information on the face of financial statements: Certain items must be explicitly disclosed on the face of the financial statements. For example, property, plant & equipment (PP&E) must be disclosed as a separate line item on the face of the balance sheet. Minimum information in the notes (or on the face of financial statements): Disclosures relating to certain items must be in the notes to the financial statements (e.g., measurement bases used). (See Table 1-3.) Comparative information: Comparative amounts should be presented for prior periods unless a specific standard permits otherwise.

©2017Wiley


Table 1-2: IAS No. 1: Minimum Required Line Items in Financial Statements5

On the face of the Slllllment of Financial Position

On the face of the Slllllment of Comprehensive Income, presented either in a single statement or in two statements (Income statement + Statement • of comprehensive income)

On the face of the Statement of Changes in Equity

Plant, property. and equipment Investment property Intangible assets Financial assets (not listed in other line items) Investments accounted for using the equity method Biological assets Inventories Trade and other receivables Cash and cash equivalents Total of assets classified as held for sale Trade and other payables Provisions Financial liabilities (not listed in other line items) Liabilities and assets for current tax Deferred tax assets and deferred tax liabilities Liabilities included in disposal groups classified as held for sale Noncontrolling interests, presented within equity Issued capital and reserves attributable to owners of the parent

Revenue Specified gains and losses for financial assets Finance costs Share of the profit or loss of associates and joint ventures accounted for using the equity method Pretax gain or loss recognized on the disposal of assets or settlement of liabilities attributable to discontinued operations Tax expense Profit or loss Each component of other comprehensive income Amount of profit or loss and amount of comprehensive income attributable to noncontrolling interest (minority interest) Amount of profit or loss and amount of comprehensive income attributable to the parent

Total comprehensive income for the period attributable to noncontrolling interests, and to owners of the parent For each component of equity, the effects of changes in accounting policies and corrections of errors For each component of equity, a reconciliation between the beginning and ending carrying amounts, separately disclosing changes resulting from profit or loss, each item of other comprehensive income, and transactions with owners in their capacity as owners

5 - Exhibit 4, Vol 3, CPA Program Curriculum 201 7

©2017Wiley


Table 1-3: Summary of IFRS Required Disclosures in the Notes to the Financial Statements•

Disclosure of accounting po licks

Measurement bases used in preparing financial statements The other accounting policies used that are relevant to an understanding of the financial statements Judgments made in applying accounting policies that have the most significant effect on the amounts recognized in the financial statements

Estimation Key assumptions about the future and other key sources of uncertainty estimation uncertainty that have a significant risk of causing

material adjustment to the carrying amount of assets and liabilities within the next year

Other disclosures • Information about capital and about certain financial instruments classified as equity Dividends not recognized as a distribution during the period, including dividends declared before the financial statements were issued and any cumulative preference dividends Description of the entity, including its domicile, legal form, country of incorporation, and registered office or business address Nature of operations and its principal activities Name of parent and ultimate parent

LOS 23f: Compare key concepts of financial reporting standards under IFRS and U.S. GAAP reporting systems. Vol 3, pg 128

Most of the differences between IFRS and U.S. GAAP are discussed in the readings that follow. A brief summary of the differences regarding financial statement elements (definition, recognition, and measurement) are:

FASB, in addition to the financial performance elements recognized under the IASB Framework (revenues and expenses), also identifies gains, losses, and comprehensive income. Reporting elements relating to financial position are defined differently. Under FASB, assets are the "future economic benefits" rather than "resources" from which future economic benefits are expected to flow under IASB. Under FASB, the word "probable" is not discussed in its revenue recognition criteria, while under IASB it is required that it is probable that a future economic benefit flow to/from the entity. FASB also has a separate recognition criterion of relevance. Regarding measurement of financial elements, both frameworks are broadly consistent. However, FASB does not allow upward revaluation of assets except for certain categories of financial instruments that must be reported at fair value.

6 - Exhibit 5, Vol 3, CFA Program Curriculum 201 7

© 2017Wiley

Companies around the world follow different frameworks in preparing their financial statements. Until recently, companies were required to report reconciliation statements


and disclosures to allow construction of financial statements as they would have been under alternative reporting standards. For example, the SEC used to (but no longer does) require reconciliation for foreign private issuers that do not prepare financial statements in accordance with U.S. GAAP. Now that reconciliation disclosures are not required, analysts must be aware of areas where accounting standards have not yet converged.

LOS 23g: Identify characteristics of a coherent financial reporting framework and the barriers to creating such a framework. Vol 3, pp 129-130

Characteristics of an Effective Financial Reporting Framework Transparency: A transparent reporting framework should reflect the underlying economics of the business. Full disclosure and fair representation create transparency. Comprehensiveness: A comprehensive reporting framework is one that is based on universal principles that provide guidance for recording all kinds of financial transactions-those already in existence and others that emerge with time. Consistency: Financial transactions of a similar nature should be measured and reported in a similar manner, irrespective of industry type, geography, and time period. However, there is also a need for flexibility to allow companies discretion to be able to report results in accordance with their underlying economic activity.

Barriers to Creating a Single Coherent Framework Valuation: When choosing a measurement base, it is important to remember the tradeoff between reliability and relevance. Historical cost is a more reliable measure of value, but fair value is more relevant over time. Standard-setting approach: Reporting standards can be based on one of the following approaches:

o A principles-based approach provides a broad financial reporting framework with limited guidance on how to report specific transactions. It requires the use of subjective judgment in financial reporting.

o A rules-based approach provides strict rules for classifying elements and transactions.

o An objectives-oriented approach is a combination of a principles-based and rules-based approach. This approach includes a framework of principles and appropriate levels of implementation guidance.

IFRS has traditionally followed a principals-based approach, while U.S. GAAP has followed a rules-based approach. The common conceptual framework is likely to lean towards more of an objectives-oriented approach. Measurement: Reporting of financial statement elements can be based on the asset/ liability approach (where the elements are properly valued at a point in time) or the revenue/expense approach (where changes in the elements are properly valued over a period of time). The former gives preference to proper valuation of the balance sheet, while the latter focuses on the income statement. The use of one of these approaches will result in more reliable information on one statement and less on the other. In recent years, standard-setters have preferred the asset/liability approach.

©2017Wiley


LOS 23h: Describe implications for financial analysis of differing financial reporting systems and the importance of monitoring developments in financial reporting standards. Vol 3, pp 131-134

LOS 23i: Analyze company disclosures of significant accounting policies. Vol 3, pp 134-137

It is important for analysts to be aware of developments in financial reporting standards and to assess their implications for security analysis and valuation. They need to understand how changes and developments affect financial reports from a user's perspective.

New products and transactions in capital markets: Certain economic events have led to the development of new products and new transactions. For example, online stores have led to the advent of e-commerce and related transactions that did not exist earlier.

Analysts should evaluate companies' financial reports to understand new transactions or products being used and implemented. Business journals, magazines, and capital markets can provide information on new transactions and financial instruments being used by various companies in an industry. Further information can always be obtained from company management regarding any products that they may have used or transactions that they might have undertaken during the year. As products or transactions become more common in the industry, it becomes imperative to understand their implications, usefulness, and impact on cash flows. Actions of standard-setting bodies, such as IASB and FASB, must be monitored because changes in regulations and financial reporting standards affect reported financial performance. Investment decision-making can be improved by keeping track of enacted and proposed changes. Company disclosures are a good source of information regarding the effects of financial reporting standards on a company's performance. Under IFRS and U.S. GAAP, companies are required to disclose accounting policies and estimates in the footnotes to the financial statements. Public companies also discuss accounting policies and estimates that require significant material judgment in the MD&A section.

Companies must also disclose information relating to changes in accounting policies. IFRS requires discussion about pending implementation of new standards and any known or estimable information relevant to assessing the impact of those standards. Clear indications regarding the expected impact of changes in standards provide the most useful information and are very helpful to analysts. Vague statements like "management is still evaluating the impact of the standard" might be red flags that analysts should be wary of. Quantified disclosures (when companies are able to quantify the expected impact of standards that have changed but are not yet effective as of the reporting date) are extremely useful to analysts.

© 2017Wiley


ANALYSIS: INCOME STATEMENTS, BALANCE SHEETS,

AND CASH FLow STATEMENTS

© 2017Wiley

UNDERSTANDING INCOME STATEMENTS

READING 24: UNDERSTANDING INCOME STATEMENI'S

LESSON 1: INCOME STATEMENT: COMPONENTS AND FORMAT

LOS 24a: Describe the components of the income statement and alternative presentation formats of that statement. Vol 3, pp 149-153

Under IFRS, the income statement may be presented as:

A section of a single statement of comprehensive income, or A separate statement (showing all revenues and expenses) followed by a statement of comprehensive income (described later) that begins with net income.

Under U.S. GAAP, the income statement may be presented as:

A section of a single statement of comprehensive income. A separate statement followed by a statement of comprehensive income that begins with net income. A separate statement with the components of other comprehensive income presented in the statement of changes in shareholders ' equity.

Exhibits 1-1and1-2 show the income statements of Van Dort Inc. (a European company) and Johnson Inc. (an American company).

Exhibit 1-1: VAN DORT INCORPORATED Income Statement

For the Year Ended December 31, 2008

2007 2008 € €

Net revenue 55,000 59,250 Cost of goods sold -39,000 -41,250 Selling expenses -6,500 -7,150 General and administrative expenses -2,250 -3,350 Research and development expenses -1,050 -1,100 Other revenue (expense) -675 -650 Trading operating income 5,525 5,750

Other operating income (expense) -105 250

[TI Operating income 5,420 6,000

Interest revenue 60 85 Interest expense -350 -275 Cost of net debt -290 --=m Other financial revenue expense -450 -750 Income before tax 4,680 5,060 Income tax -2,125 -1 ,950 Income from fully consolidated companies 2,555 ----uw Share of profits from associates 20 -50 Net income from continuing operations 2,575 3,060 Net income from discontinued operations 235 0

5 Net income 2,810 ~

4 Attributable to the group 2,529 2,754 Attributable to minority interests 281 306

©2017Wiley

Following net income, the income statement may also present earnings per share, the amount of earnings per common share of a company. Earnings per share will be discussed in detail later in this reading, and the per-share display has been omitted from these exhibits to focus on the core income statement.

@


IT! 2

m

0 [!]

Exhibit 1-2: JOHNSON INCORPORATED Income Statement

For the Year Ended December 31 , 2008

-+----- Net revenue Cost of sales

- Gross profit

Marketing, administrative, and research expenses Loss (gain) on sale of equipment Impairment expense Loss (gain) on sale of old vehicles Amortization of intangibles

- Operating income

Net interest expense Earnings from continuing operations before income taxes

Provision for income taxes Earnings from continuing operations

Earnings and gain from discontinued operations, net of income taxes

- Net earnings

- Noncontrolling interest Net earnings attributable to Johnson Incorporated

2008 2007

$ $ 15,000 13,500 11 ,050 10,075 3,950 3,425

975 695 250 0 175 105 225 275

25 55 2,300 2,295

450 430 1,850 1,865

240 135 1,610 1,730

0 55 1,610 1,785

16 18 1,594 1,767

ITJ - Revenue: Usually reported on the first line of the income statement, revenues are amounts charged (and expected to be received) for goods and services in the ordinary activities of a business. Net revenue is total revenue adjusted for product returns and amounts that are unlike! y to be collected. Other common! y used terms for revenue include sales and turnover.

Expenses reflect outflows, depletions of assets, and incurrences of liabilities in the course of the activities of a business.

[I] - Gross profit or gross margin is the difference between revenues and cost of goods that were sold. When an income statement explicitly calculates gross profit, it uses a multi-step format as opposed to a single-step format. Van Dort uses a single-step format, while Johnson uses a multi-step format.

- Operating income is calculated after subtracting all direct and indirect (period) costs from

Operating income is sometimes referred to as EBIT (earnings before income and taxes). However, they are not always equal.

revenues. It represents the profit earned by a company from its ordinary business activities before accounting for taxes and, in the case of nonfinancial companies, before deducting interest expense. Operating profits are useful in evaluating the profitability of individual businesses as they are not affected by financing decisions of the firm. Exhibits 1-1 and 1-2 contain income statements of nonfinancial companies. For financial firms, interest income and expense are part of ordinary business activities, so they are included in operating profits.

© © 2017Wiley


Net income is the "bottom line" of the income statement. It includes profits earned from ordinary business activities as well as gains and losses (increases and decreases in economic benefits) from nonoperating activities.

Net income = Revenue- Expenses in the ordinary activities of the business +Other income - Other expenses+ Gains - Losses

If a company owns the majority of the shares of a subsidiary, it must present consolidated --- 0 financial statements. Consolidation requires the parent to combine all the revenues and expenses of the subsidiary with its own and present the combined results on its income statement. If the subsidiary is not wholly owned, the share of noncontrolling interests in net income is deducted from total income, as it represents the proportionate share in the subsidiary's net income that belongs to minority shareholders.

Some subtotals are required by IFRS (especially nonrecurring items), while others are not explicitly required. Examples of items that are required to be separately stated on the face of the income statement are revenues, finance cost, and taxes.

Under IFRS, revenue from rendering of services is recognized when:

1. The amount of revenue can be measured reliably; 2. It is probable that the economic benefits associated with the transaction will flow to

the entity; 3. The stage of completion of the transaction at the balance sheet date can be

measured reliably; and 4. The costs incurred for the transaction and the costs to complete the transaction can

be measured reliably.

IFRS permits the grouping of expenses by nature or by function. An example of grouping by nature would be combining depreciation of factory equipment with depreciation of transport vehicles and stating a single aggregate amount for depreciation on the income statement. An example of grouping by function would be combining direct product costs (raw material costs and freight charges) under cost of goods sold.

Income statement presentation formats: Van Oort's and Johnson's income statements also highlight the following differences that we might run into when analyzing financial statements of various companies:

Van Dort presents the latest year in the extreme right column, while Johnson presents the most recent year on the extreme left. Van Dort presents expense items (e.g., cost of goods sold and interest expense) with negative signs to show that they are being deducted. In contrast, Johnson does not present its expenses in parentheses or with negative signs. It assumes that users know that expense items are subtracted from revenues. Van Dort deducts cost of goods sold from sales, whereas Johnson deducts cost of sales. Such differences in terminology are common across sets of financial statements.

©2017Wiley

When solving questions related to financial statement reporting and analysis, make sure you make a note of whether the most recem year is given in the rightmost column or in the leftmost. The convention used in exam questions can be different from what some of you are used to. Making an arrow indicating the movement from the oldest to the most recent accounting period will help you avoid careless mistakes in answering questions related to changes in accounting elements over the period.


@

LESSON 2: REVENUE AND EXPENSE RECOGNITION

LOS 24b: Describe general principles of revenue recognition and accrual accounting, specific revenue recognition applications (including accounting for long-term contracts, installment sales, barter transactions, gross and net reporting of revenue), and implications of revenue recognition principles for financial analysis. Vol 3, pp 153--169

LOS 24c: Calculate revenue given information tbat might influence tbe choice of revenue recognition method. Vol 3, pp 153--169

In this lesson, we will primarily discuss revenue recognition under IFRS and U.S. GAAP prior to the application of the converged standards issued in May 2014. In May 2014, the IASB and FASB each issued a nearly identical new standards for revenue recognition aimed at achieving convergence, consistency, and transparency in revenue recognition globally. We will describe these converged standards in the last part of this lesson.

The IASB Conceptual Framework defines income as "increases in economic benefits during the accounting period in the form of inflows or enhancements of assets, or decreases in liabilities that result in increases in equity, other than those relating to contributions from equity participants."1 Income includes revenues and gains. Revenues arise from ordinary, core business activities, whereas gains arise from noncore or peripheral activities. For example, for a software development company the sale of software to customers is considered revenue, but the profit on the sale of some old office furniture is classified as a gain.

The most important principle of revenue recognition is accrual accounting, which requires that revenues and costs are recognized independently of the timing of related cash flows. For example, under accrual accounting, rent expense is recognized in the month that a company uses the premises for its operations, not when the actual cash payment for rent is made. Accrual accounting allows firms to manipulate net income by recognizing revenue earlier or later, or by accelerating or deferring recognition of expenses.

Under IFRS, revenue is recognized for a sale of goods when:2

I. Significant risks and rewards of ownership are transferred to the buyer. 2. The entity retains no managerial involvement or effective control over the goods

sold. 3. The amount of revenue can be measured reliably. 4. It is probable that the economic benefits from the transaction will flow to the entity. 5. Costs incurred or to be incurred for the transaction can be measured reliably.

IFRS specify similar criteria for recognizing revenue for the rendering of service. Revenue can be estimated reliably when all the following conditions are met3

I. The amount of revenue can be measured reliably. 2. It is probable that the economic benefits associated with the transaction will flow to

the entity.

l - IASB, International Framework for the Preparation arul Presentation of Financial Statements, paragraph 70. 2 · IASB, !AS No. 18, Revenue, paragraph 14. 3 - !AS No. 18, Revenue, paragraph 20.

© 2017Wiley


3. The stage of completion of the transaction at the balance sheet date can be measured reliably.

4. The costs incurred for the transaction and the costs to complete the transaction can be measured reliably.

IFRS also specifies the criteria for recognizing interest, royalties, and dividends. These may be recognized when it is probable that the economic benefits associated with the transaction will flow to the entity and that the amount of the revenue can be measured reliably.

Under U.S. GAAP, revenue is recognized on the income statement when it is "realized or realizable and eamed."4 The SEC provides specific guidelines to determine when these two conditions are met:5

1. There is evidence of an arrangement between the buyer and seller. 2. The product has been delivered or the service has been rendered. 3. The price is determined or determinable. 4. The seller is reasonably sure of collecting money.

Revenue Recognition in Special Cases

The principles of revenue recognition listed earlier cater to most cases. However, there are some special circumstances in which revenue may be recognized prior to the sale of a good/service or even after the sale.

Long-Term Contracts

Long-term contracts are contracts that extend over more than one accounting period, such as construction projects. In long-term contracts, questions arise as to how revenues and expenses should be allocated to each accounting period. The treatment of these items depends on how reliably the outcome of the project can be measured.

Under both IFRS and U.S. GAAP, if the outcome of the contract can be measured reliably, the percentage of completion revenue recognition method is used. Under this method, revenues, costs, and profits are allocated to each accounting period in proportion to the percentage of the contract completed during the given period. The percentage that is recognized during a period is calculated by dividing the total cost incurred during the period by the estimated total cost of the project.

If the outcome cannot be measured reliably, the completed contract method is used under U.S. GAAP. Under this method, no revenues or costs are recognized on the income statement until the project is substantially finished. In the meantime, billings and costs are accumulated on the balance sheet (under a construction-in-progress asset), rather than expensed on the income statement.

Under IFRS, when the outcome cannot be measured reliably, revenue is recognized on the income statement to the extent of costs incurred during the period. No profits are recognized until all costs have been recovered.

Example 2-1 illustrates the differences between the percentage of completion method and the completed contract method.

4 - See Statement of Financial Accounting Concepts No. 5, paragraph 83(b). 5 - See SEC Staff Accounting Bulletin 101.

© 2017Wiley

Under U.S. GAAP, the completed contract method is also appropriate when the contract is not a long-tenn contract.Note, however, that when a contract is started and completed in the same period, there is no difference between the percentage of completion and completed contract methods.


Example 2-1: Revenue Recognition for Long-Term Contracts

Paxel Construction Company has a $30 million contract to construct a building. It estimates that it will take three years to complete the project. The estimated cost of the project is $21 million. Paxel incurs costs amounting to $10.5 million in Year I, $7.35 million in Year 2, and $3.15 million in Year 3. Determine the amount of revenue and profit that the company will recognize each year under IFRS and U.S. GAAP if:

I. The outcome of the contract can be reliably measured. 2. The outcome of the contract cannot be reliably measured.

Solution

Under both IFRS and U.S. GAAP, if the outcome of the contract can be measured reliably, the percentage of completion revenue recognition method is used.

Percentage of Completion Method

First we calculate the percentage of total costs incurred in each year.

Cost incurred Total cost Percentage of total cost incurred

Year 1

$10.50 $21.00

50%

Year 2

$7.35 $21.00

35%

Year3

$3.15 $21.00

15%

Then we multiply the percentage of total costs incurred each year by the total revenue earned over the term of the project to determine the amount of revenue recognized each year.

Percentage of total cost incurred

Total revenue

Revenue recognized

Year 1

50%

$30

$15

Year2

35%

$30

$10.5

Year3

15%

$30

$4.5

Net income equals revenues recognized minus costs recognized:

Revenue Costs Net income

Year 1

$15 $10.5

$4.5

Year2

$10.5 $7.35 $3.15

Year3

$4.5 $3.15 $1.35

Total

$30 $21

$9

Under IFRS, if the outcome of the contract cannot be measured reliably and it is probable that costs will be recovered, revenue may only be recognized to the extent of contract costs incurred.

Year 1: The company will recognize construction costs amounting to $10.5 million as well as revenue of $10.5 million and hence $0 income. Year 2: The company will recognize construction costs amounting to $7.35 million as well as revenue of $7.35 million and hence $0 income. Year 3: The company will recognize construction costs amounting to $3.15 million. Further, since the contract is complete, the company will also recognize the remaining revenue of $12.15 million, and therefore report $9 million in net income.

© 2017Wiley


Year 1 Year2 Year3

Revenue $10.5 $7.35 $12.15 Costs $10.5 $7.35 $3.15

Net income $0.0 $0.00 $9.00

Completed Contract Method

Under this method, no revenues or costs are recognized until the contract is completed. Therefore, for the first two years, Paxel will not recognize any revenues and costs. The entire amount of revenues, costs, and net income will be recognized in Year 3 on the income statement. On the balance sheet, for Years 1 and 2, Paxel would report all incurred costs under a "Construction-in-progress" head, which would be eliminated in Year 3.

Revenue Costs Net income

Year 1

$0 $0

$()

Year2 Year3

$30 $21

---w-

The percentage of completion method is a more aggressive (less conservative) approach to revenue recognition. It is also more subjective, as it depends on management estimates and judgment relating to the reliability of estimates. However, the percentage of completion method matches revenues with costs over time and provides smoother, less volatile earnings. Remember, cash flows are exactly the same under both methods.

important: Under IFRS and U.S. GAAP, if a loss is expected on the contract, the loss must be recognized immediately, regardless of the revenue recognition method used.

Installment Sales

An installment sale occurs when a company finances a customer's purchase of its products and customers make payments (installments) to the company over an extended period.

Under IFRS, installment sales are separated into the selling price (discounted present value of installment payments) and an interest component. Revenue attributable to the sale (selling) price is recognized at the date of sale, while the interest component is recognized over time.6 However, the standards provide that revenue should be recognized in light of local laws regarding the sale of goods. For transactions that require deferral of revenue and profit recognition (like sales of real estate on an installment basis), revenue recognition depends on specific aspects of the transaction.

Under U.S. GAAP, a sale of real estate is reported at the time of sale using the normal revenue recognition conditions if the seller:7

Has completed the significant activities in the earnings process, and Is either assured of collecting the selling price or able to estimate amounts that will not be collected.

When these two conditions are not fully met, some of the profit must be deferred and one of the following two methods may be used.

6 - lAS No. 18 IE, Illustrative Examples, paragraph 8. 7 - FASS ASC Section 360-20-55 [Property, Plant, and Equipment- Real Estate Sales-Implementation Guidance and lllustrations].

©2017Wiley @


Installment sales and cost recovery treaunentofrevenue recognition are rare for financial reporting purposes, especially for assets other than real

Installment method: This method is used when collectability of revenues cannot be reasonably estimated. Under this method, profits are recognized as cash is received. The percentage of profit recognized in each period equals the proportion of total cash received in the period.

I Profit for the period= (Cash collected in the period/Selling price)xTotal profit I Cost-recovery method: This method is used when collectability of revenues is highly uncertain. Under this method, profits are recognized only once total cash collections (including principal and interest on any financing provided to the buyer) exceed total costs. The revenue recognition method under international standards is similar to the cost recovery method, but the term "cost recovery method" is not used.

Example 2-2: The Installment Sales and Cost Recovery Methods of Revenue Recognition

Bingo Inc. sold property worth $500,000 and allowed the buyer to make the payment in installments. The cost of the property sold is $300,000. The first installment of $250,000 has been received in Year I , while the rest of the payment is expected to be received in Year 2. Calculate the amount of profit that will be recognized each year using the:

I. Installment sales method. 2. Cost-recovery method.

Solution

Installment Sales Method

Profit for the period= (Cash collected in the period/Selling price)xTotal profit

Profit (Year I)= (250,000/500,000) x 200,000 = $100,000.

Profit (Year 2) = (250,000/500,000) x 200,000 = $100,000.

Cost-Recovery Method

Under the cost-recovery method, the company will not recognize any profits in Year I because total cash received from the buyer ($250,000) does not exceed the cost of the property ($300,000). If the second installment of $250,000 is received in Year 2, Bingo will recognize a profit of $200,000 in Year 2.

© 2017Wiley


Barter Transactions

In barter transactions, goods are exchanged between two parties and there is no exchange of cash. One form of barter transaction is a round-trip transaction, in which a good is sold by one party in exchange for the purchase of an identical good. The issue with these transactions is whether revenue should be recognized.

Under IFRS, revenue from barter transactions can be reported on the income statement based on the fair value of revenues from similar nonbarter transactions with unrelated parties. Under U.S. GAAP, revenue from barter transactions can be reported on the income statement at fair value only if the company has a history of making or receiving cash payments for such goods and services and hence can use its historical experience to determine fair value. Otherwise, revenue should be reported at the carrying amount of the asset surrendered.

Gross versus Net Reporting

Under gross revenue reporting, sales and cost of sales are reported separately, whereas under net reporting only the difference between sales and cost of sales is reported on the income statement. Under U.S. GAAP, only if the following conditions are met can a company recognize revenue based on gross reporting:

The company is the primary obligor under the contract. The company bears inventory and credit risk. The company can choose its suppliers. The company has reasonable latitude to establish price.

Example 2-3: Gross versus Net Reporting of Revenues

A travel agent purchases discounted tickets and sells them to customers. The agent pays only for the tickets that she manages to sell to customers. She purchases a ticket for $1,000 and sells it for $1, I 00. Assume that there are no other revenues and expenses involved. Demonstrate the reporting of revenues under gross and net reporting.

Solution

Revenues

Cost of sales

Gross margin

Gross Reporting

$1 ,100

-$1 ,000

$100

The travel agent should report revenue on a net basis because:

Net Reporting

$100

$0

$100

She pays only for tickets that she is able to sell to customers. Therefore, she does not bear any inventory risk. The airline, not the travel agent, is the primary obligator under the contract.

©2017Wiley


Implications for Financial Analysis

Companies are required to disclose their revenue recognition policies in the footnotes to their financial statements. The impact of a chosen policy on financial analysis depends on how conservative and objective the revenue recognition policy is. A conservative policy would recognize revenue later rather than sooner, and an objective policy would not leave too many estimates to management discretion. While it is difficult to attach a monetary value to differences in revenue recognition policies, analysts should be able to assess qualitative differences between sets of financial statements and evaluate how these differences affect important financial ratios.

LOS 24d: Describe key aspects of the converged accounting standards issued by the International Accounting Standards Board and Financial Accounting Standards Board in May 2014. Vol 3, pp 166-169

Revenue Recognition Accounting Standards Issued in May 2014

By now, it should be clear to you that the different revenue recognition practices around the globe can make revenue comparisons across companies in different parts of the world quite problematic. Fortunately, in May 2014, the IASB and FASB issued a set of converged standards that look to make such comparisons easier. Under IFRS, these converged standards are effective for reporting periods beginning after January 1, 2018, while under U.S. GAAP, they are effective for reporting periods beginning after December 15, 2017. Further, IFRS pemtits early adoption of the standards, while U.S. GAAP only allows application as early as the original effective date (December 15, 2016).

Prior to the issuance of the converged standards, there were substantial differences between IFRS and U.S. GAAP when it came to revenue recognition (as we saw under the previous LOS). Generally speaking, IFRS offered limited guidance on the subject, while U.S. GAAP contained extensive guidance with several requirements. The converged standards provide a principles-based approach to revenue recognition that can be applied to different types of revenue-generating activities.

We now describe key aspects of the converged standards.

Core Principle

The core principle of the converged standards is that revenue should be recognized in order to "depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in an exchange for those goods or services." In order to attain this core principle, the standards describe five steps in recognizing revenue:

I. Identify the contract(s) with a customer. 2. Identify the performance obligations in the contract. 3. Detemtine the transaction price. 4. Allocate the transaction price to the performance obligations in the contract. 5. Recognize revenue when (or as) the entity satisfies a performance obligation.

@ ©2017Wiley


A contract is an agreement and commitment, with commercial substance, between the contacting parties. It establishes each party's obligations and rights , including payment terms. In addition, a contract exists only if collectability is probable. While IFRS and U.S. GAAP use the same word (probable), they apply a different threshold for probable collectability. Under IFRS, probable means more likely than not, whereas under U.S. GAAP, it means likely to occur. This subtle difference can result in economically similar contracts being treated differently under the two standards.

Performance obligations represent promises to transfer distinct good(s) or service(s). A good or service is distinct if (I) the customer can benefit from it on its own or in combination with readily available resources and (2) the promise to transfer it can be separated from other promises in the contract. Each identified performance obligation is accounted for separately.

The transaction price is the amount that the seller estimates it will receive in exchange for transferring the good(s) or service(s) identified in the contract to the buyer. The transaction price is then allocated to each identified performance obligation. The amount recognized reflects expectations about collectability and (if applicable) an allocation to multiple obligations within the same contract. Revenue is recognized when the obligation-satisfying transfer is made.

Acconnting Treatment When revenue is recognized, a contract asset is presented on the balance sheet. If all performance obligations have been satisfied but payment has not been received, a receivable appears on the seller's balance sheet. If payment is received in advance of transferring good(s) or service(s), the seller presents a contract liability.

For a simple contract with only one deliverable at a single point in time, completing the five steps is straightforward. Examples of more complex contracts include:

Contracts where performance obligations are met over time. Multiperiod contracts where terms are modified. Contracts where the performance obligation includes various components of goods and services, or when the compensation is variable (e.g. , bonuses for timely completion).

The examples that follow illustrate how such complex contracts are dealt with under the converged standards. As you go through these cases, notice how the end result/treatment does not deviate substantially from that under the old revenue recognition standards; instead it is just the conceptual approach and, in some cases, the terminology that differs.

Example2-4

A construction company, ABC Inc., enters into a contract with XYZ Inc. to construct a commercial building. The two parties identify several goods and services that must be provided, including pre-construction engineering, construction of the building's individual components, plumbing, electrical works, and interior finishing.

Question: When it comes to "identifying the performance obligation;' can ABC treat each specific item as a separate performance obligation to which revenue can be allocated?

©2017Wiley


Solution

The converged standards state that in order to determine whether a good or service is distinct for purposes of identifying performance obligations, (I) the customer should be able to benefit from the good or service either on its own or together with other readily available resources, and (2) the seller's promise to transfer the good or service to the customer must be separately identifiable from other promises in the contract. In this case, the second criterion is not met because the seller has been contracted to construct the building, not the separate goods and services. Therefore, when it comes to recognizing revenue, ABC cannot treat each good or service as a distinct source of revenue. Construction of the building is the single performance obligation in this contract.

Example 2-5

ABC's building construction contract with XYZ specifies consideration of $2 million. ABC expects to incur costs amounting to $1 ,700,000 to satisfy the terms of the contract. During Year 1, ABC incurs $1,190,000 in costs.

Question: Given that costs incurred accurately reflect the completion status of the contract, how much revenue should ABC recognize for Year I?

Solution

The converged standards state that when performance obligations will be satisfied over multiple accounting periods, revenue must be recognized over time based on progress made toward satisfying the obligation. Since ABC has incurred 70% (= 1, 190,000/1 , 700,000) of total expected contract costs, it will recognize $1 ,400,000 (70% of $2 million) in revenue in Year I.

Note that this is the same amount of revenue that would be recognized using the percentage-of-completion method. However, the converged standards do not make specific use of that term. They simply require that revenue be recognized based on relative completion of the performance obligation.

Example2-6

Now assume that ABC's building construction contract with XYZ is worth $2 million plus a bonus payment of $300,000 if the project is completed within two years. ABC has limited experience with similar types of contracts, and many factors outside its control (e.g., weather, regulatory reforms, availability of materials) could delay completion. ABC expects to incur $1,700,000 worth of costs to complete the building. It incurs $1,190,000 in costs Year I.

Question: Given that costs incurred provide an appropriate measure of progress toward contract completion, how much revenue should ABC recognize in Year 1?

© 2017~1ey


Solution

This example illustrates the treatment of variable consideration under the converged standards. Variable consideration may be recognized as revenue only if the company can conclude that it will not have to reverse the cumulative revenue in the future. In this example, ABC is unable to reach this conclusion due to(!) its limited experience, and (2) the various factors outside its control that could delay the project. Therefore, it cannot recognize any of the bonus as revenue in Year 1.

Example2-7

Continuing from Example 2-6, now assume that at the beginning of Year 2 the two parties to the contract agree to change the building floor plan and modify the contract. As a result, the contract will now be worth $2.2 million, and the $300,000 bonus will now be paid out as long as the project is completed in another 1.5 years (2.5 years from initiation). The changes will result in an increase in ABC's costs amounting to $150,000, but now, with an additional six months to earn the bonus, ABC believes that it does meet the criteria for being able to recognize the bonus as revenue.

Question: How should ABC account for the changes in the contract?

Solution

First of all, you should note that previous standards did not provide a general framework for accounting for contract modifications, while the converged standards do provide guidance on whether a change in a contract is a new contract or just a modification of an existing contract. In order to be considered a new contract, the change would need to involve goods and services that are distinct from the goods and services already transferred.

In this example, the changes do not meet the criteria for a new contract, so we are dealing with a modification of the contract. This requires the company to reflect the impact on a cumulative catch-up basis, where it must update the transaction price and measure of progress.

ABC's expected total revenue from the project is now $2.5 million ($2 million original amount+ $200,000 new consideration+ $300,000 completion bonus).

Its completion status is now at 64.32% ($1 ,190,000 costs incurred/total expected costs of $1,700,000 + $150,000).

Based on the updated completion status and expected total revenue, ABC must recognize a total amount of $1,608,108 (calculated as 64.32% of $2.5 million) in revenue.

ABC has already recognized $1,400,000 worth of revenue (from Example 2-5), so it must now recognize an additional $208,108 of revenue as a cumulative catch-up adjustment on the date of the contract modification.

©2017Wiley


IFRS does not specifically refer to a "matching principle," but rather toa "matching concept," or to a process resulting in "matching of costs with revenues."

The converged standards also lay down specific accounting treatments for certain related costs. For example, incremental costs of obtaining a contract and certain costs incurred to fulfill a contract must be capitalized (i.e. , reported as an asset on the balance sheet rather than as an expense on the income statement). All other factors remaining the same, if a company had expensed these incremental costs in the years prior to adopting the converged standards, its profitability will initially improve under the converged standards.

Further, the converged standards lay down rather extensive disclosure requirements:

Companies are required to disclose information about contracts with customers classified into different categories of contracts. Categories might be based on the type of product, the geographic region, the type of customer or sales channel, the type of contract pricing terms, the contract duration, or the timing of transfers. Companies are also required to disclose balances of any contract-related assets and liabilities and significant changes in those balances, remaining performance obligations and transaction prices allocated to those obligations, and any significant judgments and changes in judgments related to revenue recognition. Significant judgments are those used in determining timing and amounts of revenue to be recognized.

The converged standards will affect some industries more than others. The impact will be felt more by industries where bundled sales are common, such as telecommunications and software.

LOS 24e: Describe general principles of expense recognition, specific expense recognition applications, and implications of expense recognition choices for financial analysis. Vol 3, pp 170-180

The IASB framework defines expenses as "decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants."8

Expenses also include losses, which may or may not result from the ordinary activities of the business. The most important principle of expense recognition is the matching principle, which requires that expenses be matched with associated revenues when recognizing them on the income statement. If goods bought in the current year remain unsold at the end of the year, their cost is not included in the cost of goods sold for the current year to calculate current period profits.

Instead, the cost of these goods will be subtracted from next period's revenues once they are sold. Certain expenses (e.g., administrative costs) cannot be directly linked to the generation of revenues. These expenses are called period costs and are allocated systematically with the passage of time.

8 - lASB, Framework fo r the Preparation and Presentation of Financial Statements, paragraph 70.

© 2017Wiley


Example 2-8: Matching of Inventory Costs with Revenues

In its first year of business (2008), Brainiac Inc. made the following purchases:

Units Purchased Cost per Unit Total Cost

First Quarter 2,500 $20 $50,000

Second Quarter 3,550 $22 $78,100

Third Quarter 4,200 $25 $105,000

Fourth Quarter 3,500 $26 $91,000

TOTAL 13,750 $324,100

Brainiac sold 9,100 units during 2008 at a price of $30 per unit. Ending inventory consists of 4,650 units from the most recent purchases. Calculate total revenue and the cost of goods sold during the year.

Solution

Total revenue= 9,100 x $30 per unit= $273,000

The cost of the 9,100 units sold during 2008 will be expensed (included in COGS and matched against 2008 revenues). The cost of the remaining 4,650 units will remain in inventory.

Calculation of cost of goods sold:

First Quarter

Second Quarter

Third Quarter

TOTAL

Units Purchased

2,500

3,550

3,050

9,100

Calculation of ending inventory:

Third Quarter

Fourth Quarter

TOTAL

Units

1,150

3,500

4,650

Cost per Unit

$20

$22

$25

Cost per Unit

$25

$26

Total Cost

$50,000

$78,100

$76,250

$204,350

Total Cost

$28,750

$91,000

$119,750

To confirm that all costs ($324, I 00) are accounted for, we add the cost of inventory apportioned to COGS and the cost allocated to ending inventory.

$204,350 + $119,750 = $324,100

©2017Wiley

A detailed discussion of the various inventory accounting methods is presented in Reading 28.


The various inventory cost flow assumptions are demonstrated in Reading 28.

All three methods are allowed under U.S. GAAP. IFRS allows FIFO and weighted-average cost methods, but does not pennit use of LIFO.

In 2008, cost of goods sold will be matched against revenues as follows:

Total revenue Cost of goods sold

Gross profit

$273,000

$(204,350)

$68,650

Ending inventory ($119,750) will be matched against revenues in 2009 when these units are sold.

Inventory Methods

If a company can specifically identify which units of inventory have been sold over the year and which ones remain in stock, it can use the specific identification method for valuing its inventory. Automobiles, for example, can be valued using this method. However, if sales are composed of identical units that are sold in high volumes (e.g. , pencils), the separate identification method becomes difficult to administer. In such situations, the following methods of inventory valuation can be used:

First-in, first-out (FIFO): This method assumes that items purchased first are sold first. Therefore, ending inventory is composed of the most recent purchases. FIFO is an appropriate method for valuing inventory that has a limited shelf life. For example, older food products will be sold first to ensure that available stock is fresh.

Last-in, first-out (LIFO): This method assumes that items purchased most recently are sold first. Therefore, ending inventory is composed of the earliest purchases. The LIFO method is suitable when the physical flow of the item is such that the latest item must be sold first, for example, stacks of lumber in a lumberyard. This method is popular in the United States because of its income tax benefits.

Weighted-average cost: Under this method, total inventory costs are allocated evenly across all units. Inventory valuation and analysis are covered in detail in Reading 28.

Inventory Costing Methods

Method

FIFO

LIFO

Weightedaverage cost

Description

Costs of the earliest items purchased are included in cost of goods sold first.

Costs of the most recent purchases are included in cost of goods sold first.

Distributes total costs over total units available for sale.

Cost of Goods Sold Ending Inventory

Earliest purchases Most recent purchases

Most recent purchases Earliest purchases

Average cost Average cost

© 2017Wiley


Issues in Expense Recognition

Doubtful Accounts

When sales are made on credit, there is a possibility that some customers will not be able to meet their payment obligations. Companies can choose to wait for actual customer defaults to recognize these losses (direct write-off method). However, the matching principle requires companies to estimate bad debts at the time of revenue recognition. These estimated uncollectable amounts are expensed on the income statement for the period during which the related sales were made (they are not directly adjusted to revenues).

Warranties

When companies provide warranties for their products, there is a possibility that they might have to pay for repairing or replacing defective products in the future. Rather than recognizing these expenses only when they are actually incurred (when warranty claims are made), the matching principle requires companies to estimate future warranty-related expenses and recognize these amounts on the income statement in the period of sale, and to update this amount to bring in line with actual expenses incurred over the life of the warranty.

Depreciation

Companies incur significant costs to acquire long-lived assets that provide economic benefits over an extended period of time. Under IFRS, long-lived assets may be valued using either the cost model or the revaluation model. In contrast, U.S. GAAP permits only the use of the cost model.

Under the cost model, the asset is reported at a cost less than any accumulated depreciation. Depreciation is the process of allocating the cost of long-lived assets across the accounting periods for which they provide economic benefits. The allocation of costs to several periods matches these costs with associated revenues. With regard to depreciation, IFRS requires the following:

Each component of an asset should be depreciated separately. Estimates of residual value and useful life should be reviewed annually.

The choice of depreciation method depends on how a company expects to utilize the benefits from a long-lived asset over time.

Under the straight-line method, the cost of the asset less its estimated residual value is spread even! y over the estimated useful life of the asset. This method requires estimates of residual value and useful life. Residual value is the amount that the company expects to receive upon sale of the asset at the end of its useful life.

Under accelerated methods of recording depreciation, a greater proportion of the asset's cost is allocated to the initial years of its use and a lower proportion of the cost is allocated to later years. Accelerated methods are used when the asset is expected to be utilized more heavily in the years immediately following its purchase.

Accelerated methods of depreciation result in higher depreciation expense and lower net income in the early years of an asset's life. In later years, accelerated methods recognize less depreciation expense in every accounting period, resulting in higher net income.

©2017Wiley

Depreciation and amortization are covered in detail in Reading 29.

Note that these are not required under U.S.GAAP.

@


Amortization

Amortization refers to the allocation of the cost of an intangible asset over its useful life.

Intangible assets with identifiable useful lives are amortized evenly over their lives in the same way as long-term assets are depreciated using the straight-line method. However, there are no estimates for residual value involved in the calculation.

Intangible assets with indefinite lives (e.g., goodwill) are not amortized; instead they are tested annually for impairment. An asset is impaired when its current value is lower than its book value. If an asset is deemed impaired, an impairment charge (expense) is made on the income statement to bring its value down to its true current value.

Demonstration of Depreciation Methods

A variety of methods can be used to calculate depreciation expense. While annual depreciation expense might vary from method to method, total depreciation expense over the life of the asset will be the same under all methods.

Straight-line depreciation: An equal amount of depreciation expense is charged every year during the asset's useful life. Annual depreciation expense is calculated as:

lccost-Residual value)/Useful life I Declining balance depreciation: This is an accelerated method of depreciation, which applies a constant rate of depreciation to a declining book value. To compute depreciation expense, we must determine the straight-line rate, which equals 100% divided by the number of years that the asset is expected to remain in use. For example, if the asset 's useful life is five years, the straight-line rate would be 20% (100/5). Next, we must determine the acceleration factor, which is multiplied by the straight-line rate. The product of the two is then applied to the net book value of the asset to determine depreciation expense.

The double-declining balance (DDB) method uses an acceleration factor of 200 (it depreciates the asset at a rate that is two times the straight-line rate). Depreciation expense under the DDB method is calculated as:

1(2/Useful life)x(Cost-Accumulated depreciation) I

Unlike straight-line depreciation, the declining balance method does not explicitly take into account the residual value of the asset in determining depreciation expense each year. Under the declining balance method, the asset is depreciated only until its net book value equals its residual value.

Example 2-9 demonstrates the depreciation of long-term assets under the straight-line and double-declining balance methods.

©2017Wiley


Example 2-9: Depreciation Methods

A company purchases a new generator for its factory. The following data is available: Cost of the generator $38,000 Estimated useful life 5 years Residual value $3,000

Calculate the annual depreciation expense under the straight-line method and the double-declining balance method.

Solution

I. Straight-line depreciation; (38,000 - 3,000)/5; $7,000

2. Double-declining balance depreciation

IDDB Depreciation ; (2/Useful life)x(Cost - Accumulated depreciation) I

Every year, a 40% (2/5) depreciation rate is applied to the declining book value to determine depreciation expense.

Net book value = Historical cost - Accumulated depreciation

Net book value at the end of Year 1

DDB Depreciation Schedule ; $38,000 - $15,200; $22,800

Depreciation Accumulated Net Book Year Calculation Expense Depreciation Value

$ $ $ $

38,000

1 38,000 x 40% 15,200 15,200 ~22,800

2 22,800 x 40% ~9,120 "·'wl 13,680

3 13,680 x 40% 5,472 29,792 8,208

4 8,208 x 40% 3,283 33,075 4,925

5 4,925 - 3,000 1,925 35,000 3,000

Total $35,000 Accumulated depreciation equals total depreciation expense charged against the

I Depreciation expense for Year 2 I asset to date.

; (2/5) x ($38,000 - $15,200) ; $9,120 Accumulated depreciation at the end of Year 2; $15,200 + $9,120; $24,320

©2017Wiley

lnyearSonly Sl,925of depreciation is charged against the generator even though 4,925 x 40% equals 1,970. This is because under DOB depreciation, the asset is depreciated only until its book value equals its residual value.


Annual depreciation expense is sensitive to two estimates- residual value and useful life. An increase in the value of these two estimates would decrease yearly depreciation expense and increase reported net income. Let's tweak the information provided in Example 2-5 to illustrate this. If the residual value of the generator is increased to $6,000 (from $3 ,000) and the useful life is increased to 8 years (from 5 years), annual depreciation expense under the straight-line method would equal $4,000 [(38,000 - 6,000)/8]. The increase in residual value and useful life estimates leads to a reduction in depreciation expense (from $7,000 to $4,000).

Implications for Financial Analysis

A company's estimates for doubtful accounts and warranties and its estimates of useful lives and salvage values of long-lived assets directly affect net income. The subjective nature of these estimates allows management to manipulate reported financial statements. Therefore, when analyzing financial statements, analysts must carefully scrutinize the validity of used estimates. For example, if a company reports lower warranty expense in the current year compared to the previous year, an analyst should consider whether this is due to better and more reliable products, or because management had recognized an artificially high warranty expense in the previous period to inflate net income in the current period.

Accounting estimates should also be compared to those of other companies that operate in the same industry to check their validity and evaluate management integrity. If a company has a lower provision for doubtful accounts compared to a peer company, an analyst should assess whether this is because of stricter credit policies or because the company has a more aggressive accounting approach. As with revenue recognition, relative conservatism in expense recognition has a direct impact on reported financial ratios.

Accounting policies and estimates are disclosed in the footnotes to the financial statements and the management discussion and analysis (MD&A) section of the annual report.

LESSON 3: NON-RECURRING ITEMS, NON-OPERATING ITEMS

LOS 24f: Describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, extraordinary items, unusual or infrequent items) and changes in accounting standards. Vol 3, pp 179-185

In order to forecast a company's future earnings, analysts must project the company's revenues and expenses into the future. The most popular way of doing this is to use prior years' income and expense items as base figures , and to separate revenues and expenses that are likely to continue in the future from those that are not as likely to occur in the future (non-recurring items). Two examples of non-recurring items are discontinued operations and extraordinary items.

Discontinued Operations

Under both IFRS and U.S. GAAP, the income statement must separately report an operation as a "discontinued operation" when the company disposes of, or decides to dispose of, one of its component operations, and the component is operationally and physically separable from the rest of the firm.

Discontinued operations are reported net of tax as a separate line item after income from continuing operations (this treatment is permitted under IFRS and U.S. GAAP).

© 2017Wiley


As the disposed operation will not earn revenue for the company going forward, it will not be taken into account when formulating expectations regarding the future peiformance of the company.

Extraordinary Items

IFRS does not allow any items to be classified as extraordinary. U.S. GAAP defines extraordinary items as being both unusual in nature and infrequent in occurrence. A significant degree of judgment is involved in classifying an item as extraordinary. For example, losses caused by Hurricane Katrina in the Unites States were not classified as extraordinary items because natural disasters could reasonably be expected to reoccur.

Extraordinary items are reported net of tax and as a separate line item after income from continuing operations (below discontinued operations). Analysts can eliminate extraordinary items from expectations about a company's future financial performance unless there is an indication that these extraordinary items may reoccur. For fiscal periods beginning after December 15, 2015, U.S. GAAP will no longer include the concept of extraordinary items. Under the new guidance, items will simply be classified as unusual, infrequent, or unusual and infrequent.

The likelihood of certain other items continuing in the future is not as clear and requires analysts to make judgments regarding their impact on future profits. Two examples of such items are unusual or infrequent items and changes in accounting standards.

Unusual or Infrequent Items

These items are either unusual in nature or infrequent in occurrence. Examples of such items include restructuring charges and gains and losses arising from selling an asset for more or less than its carrying value.

These items are listed as separate line items on the income statement but are included in income from continuing operations and hence reported before-tax. Analysts should not ignore all unusual items. When forecasting future profits, analysts should assess whether each of them is likely to reoccur.

Changes in Accounting Policies A change in accounting policy could be required by standard setters or be decided on by management to provide a better reflection of the company's performance. An example of change in accounting policy is moving away from LIFO to the FIFO method of inventory valuation. Changes in accounting policies are applied retrospectively, unless it is impractical to do so. This means that financial data for all periods shown in the financial report must be presented as if the new principle were in use through the entire period. This retrospective change facilitates comparisons across reporting periods. Further, a description of and justification for the change are provided in the footnotes to the financial statements. A change in an accounting estimate (e.g., a change in the residual value of an asset), is applied prospectively and affects financial statements for only the current and future periods. No adjustments are made to prior statements and the adjustment is not shown on the face of the income statement. Significant changes in accounting estimates should be disclosed in the footnotes . A correction of prior-period errors is made by restating all prior-period financial statements presented in the financial report. In addition, disclosure about the error is required in the footnotes. Analysts should carefully assess these disclosures, as they may point to weaknesses in the company's accounting system or financial controls.

©2017 Wiley

IFRSrequires that income and expense items that are material and/ or relevant to the understanding of a company's financial perfonnance should be disclosed separately. Unusual or infrequent items meet these criteria.


LOS 24g: Distinguish between the operating and non-operating components of the income statement. Vol 3, pp 184-185

IFRS does not define operating activities. Therefore, companies that choose to report operating income or the results of operating activities need to ensure that such activities would normally be regarded as operating.

On the other hand, U.S. GAAP defines operating activities as those that generally involve producing and delivering goods and providing services, and include all transactions and

other events that are not defined as investing or financing activities.9

For example, a cloth manufacturer might receive dividend and interest income from investments in securities issued by other entities. These sources of income do not relate to the core business operations of the manufacturer and will be listed under non-operating components of net income. Interest payments on loans taken by the manufacturer are also non-operating items because interest expense is incurred due to a financing decision. Analysts typically use a firm's earnings before interest and taxes (EBIT) as a measure of its operating income. For financial services companies, however, interest expense and income are related to their core businesses and constitute operating components of their business.

LESSON 4: EARNINGS PER SHARE, ANALYSIS OF THE INCOME STATEMENT, AND COMPREHENSIVE INCOME

LOS 24h: Describe how earnings per share is calculated and calculate and interpret a company's earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures. Vol 3, pp 185-195

LOS 24i: Distinguish between dilutive and antidilutive securities, and describe the implications of each for the earnings per share calculation. Vol 3, pp 185-195

Earnings per share is one of the most important profitability measures for publicly listed firms. Earnings refer to the share of net income of a company that is owned by common shareholders only.

A firm can have a simple capital structure or a complex capital structure. A company has a simple capital structure when it does not have any financial instruments outstanding that can be converted into common stock. Firms with simple capital structures are required to report basic earnings per share (EPS) only.

Income available to common shareholders Basic EPS = ----------------

Weighted average number of shares outstanding

Net income- Preferred dividends Basic EPS = ----------------


Preferred dividends are subtracted from net income to calculate earnings available to common shareholders. This is because preferred dividends are not included in expenses on the income statement in the calculation of net income.

9 - FASS ASC Master Glossary.

© 2017Wiley


The weighted average number of shares outstanding refers to the number of shares that were outstanding over the year (adjusted for stock splits and stock dividends), weighted according to the proportion of the year that they were outstanding.

Example 4-1: Basic EPS

The information provided here pertains to Liu Pie. for the year ended December 31, 2008. Calculate basic EPS for the company.

Net income for 2008 Preferred dividends for the year Weighted average number of common shares outstanding

Solution

Basic EPS = ($2,625,000-$420,000)/600,000

= $3.68

$2,625,000 $420,000

600,000

Stock repurchases result in a decrease in the number of shares outstanding. Therefore, reacquired shares are excluded from the computation of weighted average number of shares from the date of repurchase. For example, if a company had 1,000 shares outstanding at the start of the year and repurchased 100 shares in July, the weighted average number of shares outstanding would be calculated as:

Weighted average number of shares= (1,000 x 12112)- (100 x 6/12) = 950

In contrast, stock splits and stock dividends (stock bonuses) result in an increase in the number of shares outstanding.

In a stock split, existing shares in a company are "split" into more shares. A 2-for-l stock split will increase the number of shares held by a holder of 1,000 shares by 1,000 shares to 2,000 shares. After a 3-for-2 stock split, the owner of 1,000 shares will see her shareholding increase by 500 shares to 1,500 shares. A stock dividend is a dividend paid as additional shares of stock rather than cash. These additional shares are granted to each shareholder in proportion to her current holding. After a 25% stock dividend, the holder of 1,000 shares will get 250 (25%) more shares to take her total shareholding to 1,250 shares.

Important: If a company declares a stock split or a stock dividend, the weighted average number of shares outstanding should be calculated based on the assumption that the additional (newly granted) shares have been outstanding since the date that the original shares were outstanding. Example 4-2 will clarify this important point.

©2017Wiley

We multiply the 100 repurchased sharesby(6'12) because they were repurchased in July and were not a part of the company's outstanding capital for6months.


Shares issued during lheyearenterthe computation from the date of issuance.

The stock split and stock dividend are applied to all shares outstanding prior to the split or dividend announcement. They are not applied to any shares issued or repurchased after the announcement. The stock split applies only to the I million shares outstanding at January I. The stock dividend applies to the I million shares outstanding since January I, the additional shares issued on those I million shares in the stock split, and the 500,000 shares that were issued on June30.

The if-converted method is used to calculate diluted EPS when the company has convertible securities outstanding.

Example 4-2: Basic EPS Calculation

LEM Company has reported net income of $1,850,000 for the year ended December 31, 2008. The company declared preferred dividends of $150,000. The following information regarding shares outstanding is available:

Shares outstanding at January l , 2008 1,000,000 J 2-for-1 stock split on April 1, 2008 Shares issued on June 30, 2008 500,000 10% stock dividend on September 1, 2008 Shares repurchased on October 1, 2008 150,000 Shares outstanding on December 31, 2008 2,600,000

Calculate 2008 basic EPS for LEM.

Solution

Shares outstanding on January 1 1,000,000

2-for-l stock split 1,000,000

2,000,000 VERY

10% stock dividend 200,000 IMPORTANT

Shares outstanding since January 1 (for 12 months) 2,200,000 When weighting the shares, assume that the new shares

Shares issued on June 30 500,000 issued from the stock split or stock

10% stock dividend 50,000 dividend were

Shares outstanding since June 30 (for 6 months) 550,000 outstanding NOT since date of split or stock dividend declaration, but from

Shares repurchased on October 1 the date from which

Not outstanding for 3 months 150,000 the original shares were outstanding.


= (2,200,000x 12/12)+ (550,000x6/12)-(150,000x3/12) = 2,437,500

Basic EPS = (Net income-Preferred dividends)


Basic EPS = ($1,850,000-$150,000)/2,437,500 = $0.70

A complex capital structure is one that contains certain financial instruments that can be converted into common stock (e.g., convertible bonds, convertible preferred stock, warrants, and options). These financial instruments are potentially dilutive, so companies with complex capital structures are required to report basic and diluted EPS. A dilutive security is one whose conversion into shares of common stock would result in a reduction in EPS. EPS calculated after taking into account all dilutive financial instruments in the capital structure is known as diluted EPS. Financial instruments that can be converted into common stock, but whose conversion does not reduce EPS below basic EPS, are antidilutive. Antidilutive financial instruments are not considered in the calculation of diluted EPS. Accounting standards require companies to disclose diluted EPS because this information is important for existing common shareholders.

©2017Wiley


Diluted EPS When a Company Has Convertible Preferred Stock Outstanding

If convertible preferred shares were converted into common shares:

We would add back dividends paid to convertible preferred shareholders to our numerator (earnings available to common shareholders). This is because the company would not be required to pay any preferred dividends on convertible preferred shares if these shares were converted into ordinary shares. We would increase the number of shares outstanding by the number of common shares that would be issued to convertible preferred shareholders upon conversion.

Diluted EPS = Net income- Preferred dividends+ Convertible preferred dividends

Weighted average number of shares outstanding+ New common shares issued upon conversion

Example 4-3: Diluted EPS

Xingia Inc. earns profits of $2,500,000 for the year ended December 31 , 2008. Xingia has 1,000,000 weighted average shares outstanding during the year and pays taxes at the rate of 40%. Xingia also has 1,000 convertible preferred shares outstanding, which pay a dividend of $50 per share every year. Each convertible preferred share can be converted into 100 common shares. Calculate Xingia's basic and diluted EPS for 2008.

Solution

Basic EPS = ($2,500,000 - $50,000)/1 ,000,000 = $2.45

Each preferred share can be converted into 100 shares of common stock. Therefore:

Number of common shares issued upon conversion= 100 x 1,000 = 100,000

Diluted EPS = ($2,500,000 - $50,000 + $50,000)/(1,000,000 + 100,000) = $2.27

Since basic EPS equals $2.45 and EPS assuming that convertible preferred shares are converted is lower ($2.27), the convertible preferred shares are dilutive. If EPS after conversion were greater than basic EPS, these shares would be antidilutive and would not be included in the calculation of diluted EPS.

A quick way to determine whether convertible preferred shares are dilutive is by calculating:

Convertible preferred dividends

New shares issued upon conversion

If this per share figure is lower than basic EPS, the convertible preferred shares are dilutive, and should be included in the calculation of diluted EPS. If this figure is greater than basic EPS, the convertible preferred shares are antidilutive and should be ignored in the calculation of diluted EPS.

©2017Wiley


The preference shares in this example cannot be converted into ordinary shares, so they are not considered in the calculation of diluted EPS.

Diluted EPS When a Company Has Convertible Debt Outstanding

If convertible bonds were converted into ordinary shares:

We would add interest payments that were made to bondholders back to the numerator. This is because the company would not be required to make any interest payments to holders of convertible bonds if these bonds were converted to ordinary shares. However, the increase in earnings available to common shareholders is not the entire amount of interest savings from inversion. Recall that interest expense is deducted from operating profits before the calculation of net income before tax, so interest expense results in a tax shield for the company. Interest savings adjusted for the tax shield benefits that have already been realized will be added to the numerator.

The number of shares outstanding will increase by the number of common shares that would be issued to convertible debt holders upon conversion.

Diluted EPS _ Net income - Preferred dividends+ Convertible debt interest x (l -1)

Weighted average number of shares outstanding + New common shares issued upon conversion


Xingia Inc. earns profits of $2,500,000 for the year ended December 31, 2008. Xingia has a weighted average of 1,000,000 shares outstanding during the year and pays taxes at the rate of 40%. Xingia has 1,000 preferred shares outstanding, which offer a dividend of $50 per share every year. Xingia also has $75,000 par of 10% convertible bonds outstanding, which are convertible into 7 ,000 shares of common stock. Calculate Xingia's basic and diluted EPS for 2008.

Solution

Basic EPS ; ($2,500,000 - $50,000)/1,000,000 shares; $2.45

To deterntine diluted EPS, we must first calculate the after-tax interest on convertible debt.

After-tax interest on convertible debt; $7,500 (1 - 0.40); $4,500

The convertible bonds can be converted into 7,000 shares of common stock.

Diluted EPS ; ($2,500,000 - $50,000 + $4,500)/(1 ,000,000 + 7 ,000); $2.43

Since basic EPS is $2.45 and EPS assunting that convertible bonds are converted is lower ($2.43), the company's outstanding convertible bonds are dilutive, and diluted EPS for 2008 equals $2.43.

© 2017Wiley


A quick way to determine whether convertible bonds are dilutive is by calculating:

Convertible bond interest (1-1)

New shares issued upon conversion

If this per share figure is lower than basic EPS, the convertible bonds are dilutive and should be included in the calculation of diluted EPS. If this figure is greater than basic EPS, the convertible bonds are antidilutive and should be ignored in the calculation of diluted EPS.

Diluted EPS When a Company Has Stock Options, Warrants, or Their Equivalents Outstanding

In the calculation of diluted EPS, stock options and warrants are accounted for using the treasury stock method (required under U.S. GAAP). The treasury stock method assumes that all the funds received by the company from the exercise of options and warrants are used by the company to repurchase shares at the average market price for the period. The resulting net increase in number of shares outstanding equals the increase in shares from the exercise of options and warrants minus the number of shares repurchased.

Stock options and warrants are assumed to be exercised if the strike or exercise price is lower than the average market price during the year. The proceeds to the company from the exercise of the options equal the exercise price multiplied by the number of options. These proceeds are used to repurchase shares at the average market price. In calculating diluted EPS:

No adjustment must be made to the numerator because the exercise of options or warrants has no impact on income available to common shareholders. The number of shares outstanding increases by the number of shares issued upon exercise of options minus the number of shares repurchased with the proceeds of option exercise. A shortcut for calculating the net increase in the number of shares is:

Market price- Exercise price Number of shares created Market price x from the exercise of options

Diluted EPS = ___________ N_e_t m_· _co_m_e __________ _ Weighted average number of shares outstanding+ New shares issued at option exercise - Shares repurchased from proceeds of option exercise

©2017Wiley

Year-end stock prices do NOTmauerin determining whether options and warrants are exercised.

IFRS requires the use of asimilar method, but does notrefertoitas the treasury stock method. The proceeds of option exercise are assumed to be used to repurchase shares at the average market price and these shares are known as inferred shares. The excess of new issued shares over inferred shares is added to the weighted average number of shares outstanding.

@



Xingia Inc. earns profits of $2,500,000 for the year ended December 31 , 2008. Xingia has 1,000,000 shares outstanding during the year and pays taxes at the rate of 40%. Xingia paid preference dividends amounting to $50,000 in 2008. The average market price of Xingia's stock over the year was $50. Xingia has 10,000 stock options outstanding, which have an exercise price of $30. Calculate Xingia's diluted EPS for 2008.

Solution

Since the average market price exceeds the exercise price of the options, they should be assumed to have been exercised.

Number of common shares issued to option holders ; 10,000

Cash proceeds from exercise of options; $300,000 (10,000 shares x $30)

Number of shares that can be purchased at average market price with these funds ; $300,000/$50 ; 6,000

Net increase in common shares outstanding from the exercise of options ; 10,000 - 6,000 ; 4,000

Diluted EPS; $2,500,000 - $50,000/(1,000,000 + 10,000 - 6,000); $2.44

Diluted EPS ($2.44) is lower than basic EPS ($2.45). Therefore, the options are dilutive and should be considered in the calculation of diluted EPS.

When options/warrants are exercised (average market price is greater than exercise price) they result in an increase in the number of shares outstanding. Because their exercise has an impact on only the denominator of the EPS formula, options and warrants are always dilutive if exercised.

Now let's calculate diluted EPS for Xingia assuming that all three types of potentially dilutive financial instruments are present in its capital structure.

Important: In determining which potentially dilutive financial instruments should be included in the diluted EPS calculation, each of the financial instruments must be evaluated individually and independently to determine whether they are dilutive. If there are any antidilutive financial instruments, they must be ignored in the diluted EPS calculation.

© 2017Wiley



Xingia Inc. earns profits of $2,500,000 for the year ended December 31, 2008. Xingia has 1,000,000 weighted average shares outstanding during the year and pays taxes at the rate of 40%. The average market price of Xingia's stock over the year was $50. Xingia has 1,000 convertible preferred shares outstanding, with each share convertible into 100 shares of common stock. It pays a dividend of $50 per share on these shares. Xingia also has $75,000 par of 10% convertible bonds outstanding, which are convertible into 7,000 shares of common stock. Further, it has 10,000 stock options outstanding, which have an exercise price of $30. Calculate Xingia's basic and diluted EPS for 2008.

Solution

Basic EPS = ($2,500,000-$50,000)/1,000,000 shares= $2.45

DilutedEPS

In Examples 4-3, 4-4, and 4-5, we have already detennined that all three potentially dilutive financial instruments are, in fact, dilutive. Xingia's diluted 2008 EPS is calculated as:

[Net income -Prefi rred ] Convertible [ Convertible ] d" -~ d + preferred + debt x (1 -t)

Diluted EPS = ivi en s dividends interest

Weighted Shares from Shares from Shares conversion of conversion of average + convertible +

convertible + issuable from

shares preferred shares debt stock options

Diluted EPS = 2,500,000-50,000+50,000+ 7,500(1-0.4) 1,000,000+ 100,000+ 7,000+4,000

$2.25

©2017Wiley


Example 4-7: Antidilutive Financial Instruments

Acme Inc. reported a net income of $2,500,000 over the year. During the year its weighted average number of common shares outstanding was 1,000,000. Acme also had 25,000 convertible preferred shares outstanding on which it paid a dividend of $7 per share. Each of these shares are convertible into 2 shares of common stock. Calculate basic EPS and diluted EPS for Acme for the year.

Solution

Basic EPS = [(2,500,000 - 175,000)/1,000,000] = $2.33

Diluted EPS

If the convertible preferred shares were converted into common shares, EPS would equal:

($2,500,000-$175,000+$175,000)/(l,OOO,OOO+ 50,000) = $2.38

EPS assuming the convertible preferred shares are converted into common stock ($2.38) is greater than basic EPS ($2.33). The convertible preferred shares are antidilutive, and should not be included in the calculation of diluted EPS. The firm 's diluted EPS is therefore the same as its basic EPS of $2.33.

One final note: If dilutive financial instruments were issued during the year, the denominator of the diluted EPS formula would increase by the number of shares issued upon conversion/ exercise multiplied by the proportion of the year for which they were outstanding. For example, if dilutive convertible preferred shares that can be converted into 10,000 shares of common stock were issued after 9 months of the accounting year had passed, the denominator of the diluted EPS formula would be increased by 10,000 x (3112) = 2,500.

Note: Both U.S. GAAP and IFRS require the presentation of EPS (basic EPS and diluted EPS) on the face of the income statement.

LESSON 5: ANALYSIS OF THE INCOME STATEMENT AND COMPREHENSIVE INCOME

LOS 24j: Convert income statements to common-size income statements. Vol 3, pp 195-199

LOS 24k: Evaluate a company's financial performance using common-size income statements and financial ratios based on the income statement. Vol 3, pp 195-199

Analysis of the Income Statement

Common-size income statements present each line item on the income statement as a percentage of sales. The standardization of each item removes the effect of company size and facilitates financial statement analysis, as the data can be used to conduct time-series (across time periods) and cross-sectional (across companies) analysis.

While common-size income statements present most items as a percentage of sales, it is more appropriate to present income taxes as a percentage of pre-tax income. This ratio is known as the company's effective tax rate. In cross-sectional analysis, effective tax rates are compared across companies and sources of any differences are analyzed in detail.

© 2017Wiley


Exhibit 5-1 presents common-size income statement of Liuson Company. Notice that the provision for income taxes has been expressed as a percentage of income before tax.

Exhibit 5-1: Common-Size Income Statement

Liuson Company Common-Size Income Statement For the year ended 2006 and 2007

Total revenue Cost of goods sold

Gross profit

Operating expenses

General expenses Depreciation

Operating income

Interest income Interest expense

Other losses

Income before income taxes Provision for income taxes Net income

2006

$

400,000

(320,000)

80,000

(28,000)

(8,000)

44,000

3,000

(400)

(1,800)

44,800

(16,000)

28,800

2006 2007

% $

100.00 500,000

80.00 (380,000)

20.00 120,000

7.00 (29,000)

2.00 (12,000)

11.00 79,000

0.75 2,000

0.10 (1 ,800)

0.45 (4,200)

11.20 75,000

35.71 (21 ,000)

7.20 54,000

The things that stand out in Liuson's common-size statements are that:

2007

%

100.00

76.00

24.00

5.80

2.40

15.8

0.40

0.36

0.84

15.00

28.00

10.80

Cost of goods sold has decreased from 80% to 76% of sales, so the gross margin has increased. General expenses decreased from 7% to 6% of sales. The net profit margin has increased significantly from 7% to 11 %.

This implies that management is effectively controlling costs in order to boost profitability. Common-size income statements are discussed in detail in Reading 27.

Income Statement Ratios

Items listed on the income statement are used to calculate ratios to evaluate a company's profitability. Gross profit margin and net profit margin are the two most commonly used indicators of profitability.

Net profit margin= Net income/Revenue Gross profit margin = Gross profit/Revenue

Any subtotal on the income statement can also be expressed as a margin ratio by dividing it by total revenue. For example, operating margin is calculated as operating income (EBIT) divided by sales, and pre-tax margin is calculated as earnings before tax (EBT) divided by total revenue.

©2017Wiley

Income statement ratios are discussed in more detail in Reading 28.


Comprehensive income =Net income plus other comprehensive income

Also note that the "available-for-sale" classification no longer appears in lFRS as of 2010, although the relevant standard (lFRS 9 Financial Instruments) is not effective until 2018. However, although the available-forsale category will not exist, IFRS will still pennit certain equity invesunents to be measured at fair value with any unrealized holding gains or losses recognized in other comprehensive income if they are classified as financial assets measured at fair value through other comprehensive income.

LOS 241: Describe, calculate, and interpret comprehensive income. Vol 3, pp 199-202

LOS 24m: Describe other comprehensive income, and identify the major types of items included in it. Vol 3, pp 199-202

Most revenues, gains, expenses, and losses are reported on the income statement to determine a company's net income. However, there are certain income and expense items that are excluded from the income statement; instead these items are reported directly in shareholders' equity (U.S. GAAP only), or in a separate statement of comprehensive income (IFRS and U.S. GAAP) as a part of other comprehensive income.

IFRS defines total comprehensive income as "the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners." 10

Under U.S. GAAP, comprehensive income is defined as "the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners." 11

Comprehensive income includes both net income and other revenues and expenses that are excluded from the net income calculation (other comprehensive income). Both net income and other comprehensive income have an impact on retained earnings.

Beginning shareholders' equity+ Net income+ Ending shareholders' equity = Other comprehensive income - Dividends declared

Suppose a company's beginning shareholders ' equity was $100 million. Its net income for the period was $10 million, and it declared $1 million as dividends. There was no repurchase or issuance of common stock during the year and the company's year-end shareholders ' equity stood at $130 million. The company's other comprehensive income will be calculated as:

Other comprehensive income= $130m - lOOm - !Om+ Im= $21 million

Items Classified as Other Comprehensive Income

Four types of items are classified as other comprehensive income under both IFRS and U.S. GAAP:

1. Foreign currency translation adjustments. 2. Certain costs relating to the company's defined benefit post-retirement plans. 3. Unrealized gains or losses on derivatives contracts, accounted for as hedges. 4. Unrealized holding gains and losses on available-for-sale securities.

Under IFRS, certain changes in the value of long-lived assets that are measured using the revaluation model (as opposed to the cost model) at fair value are also included in other comprehensive income.

10 - !AS I, Presentation of Financial Statements, paragraph 7. 11 - FASS ASC Section 220-10-05 [Comprehensive Income-Overall- Overview and Background].

© 2017Wiley

Example 5-1: Calculating Comprehensive Income

Company XYZ - Selected Financial Statement Data

Net income Dividends received from available-for-sale securities Untealized gain from foreign currency translation adjustment Dividends paid Reacquisition of common stock Untealized loss on derivatives (those considered as hedges) Untealized gain on available-for-sale securities Realized loss on sale of machinery

$1,000 60 20

(100) (300)

(20) 15

(50)


Comprehensive income equals net income plus other comprehensive income

Net income Untealized gain from foreign currency adjustment Untealized loss on derivatives considered as hedges Unrealized gain on available-for-sale securities Comprehensive Income

Important points:

$1,000 20 Other

(20) 1

r---+--. comprehensive 15 _J income = $15

$1,015

We do not include dividends from available-for-sale securities and the realized loss on machinery in other comprehensive income because they are already included in net income.

We do not include reacquisition of common stock and dividends paid in the calculation because they are transactions that relate to owners. Other comprehensive income does not include the effect of investments by owners and distributions to owners. These transactions are accounted for in the statement of changes in shareholders' equity.

When comparing the financial performances of companies, it is very important for analysts to examine significant differences in overall comprehensive income (as opposed to simply focusing on net income).

©2017Wiley

UNDERSTANDING BALANCE SHEETS

READING 25: UNDERSTANDING BALANCE SHEETS

LESSON 1: BALANCE SHEET: COMPONENTS AND FORMAT

The balance sheet (also called the statement of financial position or statement of financial condition) provides users with information regarding a company's assets , liabilities, and equity at a specific point in time. It also provides insights into the future earnings capacity of the company as well as indications regarding expected cash flows.

LOS 25a: Describe the elements of the balance sheet: assets, liabilities, and equity. Vol 3, pp 212-213

Assets

Assets are resources under a company's control as a result of past transactions that are expected to generate future economic benefits for the company.

Liabilities

Liabilities are a company's obligations from previous transactions that are expected to result in outflows of economic benefits in the future.

Assets and liabilities may arise from business transactions (e.g., the purchase of a piece of equipment) or as a result of accrual accounting. Differences between the timing of revenue and expense recognition (based on accrual accounting) and the timing of related cash flows give rise to current assets and liabilities.

Assets and liabilities should only be recognized on the financial statements if it is probable that the future economic benefits associated with them will flow to or from the firm, and that the item's cost or value can be measured with reliability.

Equity

Equity represents the residual claim of shareholders on a company's assets after deducting all liabilities. Other terms commonly used for shareholders ' equity include stockholders ' equity, net assets, and owners ' equity. Equity can be created as a result of operating activities (business transactions that yield operating profits) and financing activities (issuance of common stock).

LOS 25b: Describe the uses and limitations of the balance sheet in financial analysis. Vol 3, pg 213

The balance sheet provides useful information regarding a company's financial position to both investors and lenders. However, balance sheet information should be interpreted carefully. Analysts should be careful not to view equity reported on the balance sheet as either the market or intrinsic value of a company's net assets because of the following reasons:

Under current accounting standards, measurement bases of different assets and liabilities may vary considerably. For example, some assets and liabilities may be measured at historical cost, while others may be measured at current value. These differences can have a significant impact on reported figures.

©2017Wiley


For a company, liquidity refers to the company's ability to meet short-term cash requirements. For an individual asset, liquidity refers to how quickly the asset can be converted to cash at a price close to its fair market value.

The value of items reported on the balance sheet reflects their value at the end of the reporting period, which may not necessarily remain "current" at a later date. The balance sheet does not include qualitative factors (e.g., reputation, management skills, etc.) that have an important impact on the company's future cash-generating ability and therefore, its overall value.

Latter sections of this reading and other subsequent readings will comprehensively illustrate the use of balance sheets in evaluating the financial strength of a company.

LOS 25c: Describe alternative formats of balance sheet presentation. Vol 3, pp 213--214

Balance sheets may be presented in any of the following formats:

Report format: Assets, liabilities, and equity are presented in a single column. This format is the most commonly used balance sheet presentation fonnat. Account format: Assets are presented on the left-hand side of the balance sheet, with liabilities and equity on the right-hand side. Classified balance sheet: Different types of assets and liabilities are grouped into subcategories to give a more effective overview of the company's financial position. Classifications typically group assets and liabilities into their current and non-current portions. Liquidity-based presentation:IFRS allows the preparation of a balance sheet using a liquidity-based presentation fonnat (rather than a current/non-current fonnat), if such a format provides more reliable and relevant information. In a liquidity-based presentation, all assets and liabilities are broadly presented in order of liquidity. This format is typically used by banks.

We will use the balance sheet of Nexen Company (Exhibit 1-1) to describe current and non-current assets and liabilities that are typically found on balance sheets.

©2017Wiley


Exhibit 1-1: Sample Balance Sheet

Nexen Company Balance Sheet

2008 2007 $ $

ASSETS

I Current Assets 22,000 18,500 Cash and cash equivalents • 6 ,000 4,500 Nexen uses the Marketable securities • 5,000 6,000 title Balance Sheet.

Trade receivables • 4,000 2,000 Other companies use "Statement of

Inventories • 6 ,000 5,500 Financial Position."

Other current assets • 1,000 500

I Noncurrent Assets 81,000 57,500 Property, plant, and equipment • 50,000 40,000 Goodwill . 10,000 8,000 Other intangible assets 6,000 2,000 Non-current investments (subsidiaries) 15,000 7,500

TOTAL ASSETS 103,000 76,000

LIABILITIES AND EQUITY

I Current Liabilities 24,500 14,000 Trade and other payables • 7 ,000 3,000 Current borrowings • 6,000 2,000 Current portion of non-current borrowings • 3,000 2,000 Current taxes payable • 4,000 4,000

Accrued liabilities • 2,500 1,500 Unearned revenue I 2,000 1,500

I Non-current Liabilities 37,000 25,000 Non-current borrowings 25,000 15,000 Deferred taxes 10,000 8,000 Noncurrent provisions 2,000 2,000

TOTAL LIABILITIES 61,500 39,000

I EQUITY 41,500 37,000 Common stock 25 ,000 25,000

Preferred shares • 5,000 5,000 Reserves 2 ,000 0

Retained earnings • 12,500 9,000 Shares repurchased (Treasury stock) • (3,000) (2,000)

TOTAL LIABILITIES AND 103,000 76,000 SIIAREHOLDERS' EQUITY

© 2017Wiley @


We shall study working capital management in greater detail in Reading 39.

LESSON 2: ASSETS AND LIABILITIES: CURRENT VERSUS NON-CURRENT

LOS 25d: Distinguish between current and non-current assets and current and non-current liabilities. Vol 3, pp 215-217

IFRS and U.S. GAAP Balance Sheet Presentation

Both IFRS and U.S. GAAP require that assets and liabilities be grouped separately into their current and non-current portions, which makes it easier for analysts to examine the company's liquidity position as of the balance sheet date. However, it is not required that current assets be presented before non-current assets, or that current liabilities be presented before non-current liabilities (even though this is the case in Nexen's balance sheet). Further, under IFRS, the current/non-current classifications are not required if a liquiditybased presentation provides more relevant and reliable information .

• +-- Current assets: These are liquid assets that are likely to be converted into cash or realized within one year or one operating cycle, whichever is longer. The operating cycle is the average time taken by a company to convert the funds used to purchase inventory or raw materials into cash proceeds from sales to customers. Current assets may be listed in order of liquidity, with cash being the first item listed .

• +-- Non-current assets (also known as long-term or long-life assets): These are less liquid assets and are not expected to be converted into cash within one year or within one operating cycle. They represent the infrastructure that the firm uses in its operations and other investments made from a strategic or long-term perspective .

• +-- Current liabilities: These are obligations that are likely to be settled within one year or one operating cycle, whichever is longer. Specifically, a liability may be classified as a current liability if:

It is expected to be settled in the entity's normal operating cycle; It is primarily held for the purpose of trading; It is due to be settled within one year after the balance sheet date; or The entity does not have an unconditional right to defer settlement of the liability for at least one year after the balance sheet date. 1

IFRS allow some liabilities such as trade payables and accruals for employees to be classified as current liabilities even though they might not be settled within one year .

• +-- Non-current liabilities: These liabilities are not expected to be settled within a year or within one operating cycle. Non-current liabilities are a source of long-term finance for a company.

Working capital: The difference between current assets and current liabilities is known as working capital. Working capital is necessary for the smooth functioning of a firm's daily operations. Low working capital levels suggest that the company might be unable to meet its short-term obligations. Excessively high levels of working capital indicate that the company is not utilizing its resources efficiently.

1 - !AS I, Presentation of Financial Statements, paragraph 69.

© 2017Wiley

UNDERSTANDING BALJ\NCESHEETS

LOS 25e: Describe different types of assets and liabilities and the measnrement bases of each. Vol 3, pp 217-241

Individual assets and liabilities are reported on the balance sheet using different measurement bases. The challenge for analysts lies in understanding how the reported values of assets and liabilities relate to economic reality and to each other. As stated previously, balance sheet values should not be assumed to be accurate measures of the value of a company. For example, land is usually presented at its historical cost. If prices have increased significantly since the date of acquisition, the total value of assets is understated on the balance sheet. The balance sheet provides important information about the value of certain assets and information about expected future cash flows, but does not always accurately represent the value of the company as a whole.

Current Assets

These are assets that can be liquidated or consumed by the company within one year, or one ----+ II operating cycle, whichever is greater. Accounting standards require that certain specific line items must be shown on a balance sheet if they are material (e.g., cash and cash equivalents, trade and other receivables, inventories, and financial assets [with short maturities]).

Cash and cash equivalents --+ •

Cash equivalents are highly liquid securities that usually mature in less than 90 days. Since they are so close to maturity, there is minimal risk of any change in their value due to changes in interest rates. Since cash equivalents are financial assets, they may be measured at amortized cost or fair value.

Amortized cost equals historical cost adjusted for amortization and impairment. Fair value under IFRS equals the amount at which the asset can be exchanged in an arm's length transaction between willing and informed parties. Under U.S. GAAP, fair value is based on exit price-the price received to sell an asset.

The amortized cost and fair values of cash equivalents are usually very similar.

Marketable securities

These are also financial assets and include investments in debt and equity securities that are traded on public markets. Their balance sheet values are based on market price.

Trade receivables

Also considered financial assets, trade receivables represent amounts owed to the company by customers to whom sales have been made. These amounts are usually reported at net realizable value (an estimate affair value based on the company's expectations regarding collectability).

The relation between accounts receivable and sales is important. A significant increase in accounts receivable relative to sales may imply that the company is having problems collecting cash from customers. An increase in the allowance for doubtful accounts (the company' s estimate of uncollectable amounts) results in a lower value reported under trade receivables (assets), and bad debts (expense) being reported on the income statement. The more diversified the customer base, the lower the credit risk of accounts receivable.

©2017Wiley

-· -· The provision for doubtful accounts iscalleda contraassetaccount as it is netted against accounts receivable (an asset account).


II +---- Inventories

Inventory valuation methods, writedowns, and analysis are covered in depth in Reading 28.

These are physical stocks held by the company in the form of finished goods, work-inprogress, or raw materials. Measurement of inventory differs under IFRS and U.S. GAAP.

Under IFRS, inventory is reported at the lower of cost and net realizable value (NRV). Under U.S. GAAP, inventory is reported at the lower of cost and market.

NRV is calculated as selling price minus selling costs, while cost is determined by the cost flow assumption (LIFO, FIFO, or average cost) that is used. Market value (under U.S. GAAP) equals the current replacement cost of inventory, which must lie between NRV minus the normal profit margin and NRV.

Inventory costs should include direct materials, direct labor, and overheads. However, the following amounts should not be included when calculating inventory cost:

Abnormal amounts of wasted materials, labor, and overheads. Storage costs incurred after the production process is complete. Administrative overheads. Selling costs.

In limited cases, standard cost or the retail method can be used for valuing inventory. Standard cost should take into account normal levels of materials, labor, and actual capacity. The retail method reduces selling price by gross profit margin to determine the cost of inventory.

Once inventory is sold, its cost is reported as an expense in the income statement under "cost of goods sold."

II +- Other current assets

Items that are not material enough to be reported as a separate line item on the balance sheet are aggregated into a single amount and reported as "other current assets." These may include the following:

Prepaid expenses are normal operating expenses that have been paid in advance, so they are recognized as assets on the balance sheet. Over time, they are expensed on the income statement and the value of the asset is reduced. For example, suppose that at the beginning of the year a company makes a payment of $60,000 as advance payment for a year's rent. This results in reduction in cash of $60,000 and a corresponding increase in prepaid expenses (asset). At the end of the first quarter, three months rent of $15,000 will be expensed and the prepaid rent asset will be decreased by $15 ,000. By the end of the year, the entire $60,000 would have been charged as an expense on the income statement and the balance of the prepaid rent asset account will be zero.

Deferred tax assets (OTA) usually arise when a company's taxes payable exceed its income tax expense. They represent a kind of prepayment of taxes and therefore, count as assets. OTA will be discussed in more detail in Reading 30.

© 2017Wiley


Current Liabilities

These are a company's obligations that are expected to be settled within one year or one operating cycle, whichever is greater. Current liabilities that are typically found on the balance sheet include the following:

Trade payables (accounts payable) These are amounts owed by the business to its suppliers for purchases on credit. Analysts are usually interested in examining the trend in the levels of trade payables relative to purchases to gain insight into the company's relationships with its suppliers.

Notes payables (cnrrent borrowings) These financial liabilities are borrowings from creditors that are documented by a loan agreement. Depending on the agreed repayment date, notes payable may also be included in non-current liabilities.

Cnrrent portion of long-term liabilities These represent portions of long-term debt obligations that are expected to be paid within a year of the balance sheet date or within one operating cycle, whichever is greater.

Income taxes payable These are taxes (based on taxable income) have not actually been paid yet.

Accrued liabilities These are expenses that have been recognized on the income statement but have still not been paid for as of the balance sheet date.

-· -· -· • -· -·

Unearned revenue (deferred revenue or deferred income) - • This arises when a company receives cash in advance for goods and services that are still to be delivered. The company is obligated to either provide the goods or services or to return the cash received.

Non-Current Assets - •

Non-current assets typically include the following:

Property, plant, and equipment (PP&E) These are long-term assets that have physical substance. Examples of tangible assets treated as PP&E include land, plant, machinery, equipment, and any natural resources owned by the company.

Under IFRS, PP&E may be valued using either the cost model or the revaluation model. However, companies need to ensure that the chosen method is applied to all the assets within a particular class of assets. U.S. GAAP only allows the cost model for reporting PP&E.

Investment property IFRS defines investment property as property that is owned (or leased under a finance lease) for rental income and/or capital appreciation. Under IFRS, investment property may be valued using the cost model or the fair value model. The chosen model must be applied to all investment properties held by the company. Further, a company may only use the fair value model if it is able to determine the fair value of the investment property on a continuing basis with reliability. U.S. GAAP does not include a specific definition for investment property.

©2017Wiley

-· The cost and revaluation models for PP&E along with impainnent and invesunent property are discussed in more detail in Reading 29.


We will study the accounting standards related to intangible assets in detail in Reading 29.

Intangible assets These are identifiable, non-monetary assets that lack physical substance. Under IFRS, intangible assets may be reported using either the cost model or the revaluation model. However, the revaluation model can only be selected if there is an active market for the asset. U.S. GAAP only allows the cost model.

Intangible assets with finite useful lives are amortized systematically over their lives and may also be impaired depending on circumstances. Impairment principles for these assets are the same as those that apply to PP&E. Intangible assets with indefinite useful lives are not amortized, but are tested for impairment at least annually.

Financial statement disclosures provide important information (e.g., useful lives, amortization rates and methods) regarding a company's intangible assets.

Identifiable intangible assets can be acquired singly and are usually related to rights and privileges that accrue to the their owners over a finite period. Under IFRS, identifiable intangible assets may only be recognized if it is probable that future economic benefits will flow to the company and the cost of the asset can be measured reliably. A company may develop intangible assets internally, but such assets can only be recognized under certain circumstances. Under both IFRS and U.S. GAAP, costs related to the following are usually expensed:

Start-up and training costs. Administrative and overhead costs. Advertising and promotion costs. Relocation and reorganization costs.

Acquired intangible assets may be reported as separately identifiable intangibles (rather than goodwill) if:

They arise from contractual rights (e.g., licensing agreements), or other legal rights (e.g., patents); or Can be separated and sold (e.g., customer lists) .

• +- Goodwill (an example of an asset that is not separately identifiable) is the excess of the amount paid to acquire a business over the fair value of its net assets. The purchase price may exceed the fair value of the target company's identifiable (tangible and intangible) net assets because of the following reasons:

Note that goodwill ison1ycreated (recognized) in a purchase acquisition. Internally generated goodwill is expensed.

Certain items of value (e.g., reputation, brand) are not recognized in a company's financial statements. The target company may have incurred research and development expenditures that may have not been recognized on its financial statements but do hold value for the acquirer. The acquisition may improve the acquirer's position against a competitor or there may be possible synergies.

Analysts must understand the difference between accounting and economic goodwill. Accounting goodwill is based on accounting standards and is only reported for acquisitions when the purchase price exceeds the fair value of the acquired company's net assets. Economic goodwill, which is not reflected on the balance sheet, is based on a company's performance and its future prospects. Analysts are more concerned with economic goodwill as it contributes to the value of the firm and should be reflected in its stock price.

©2017Wiley

Under U.S. GAAP and IFRS, accounting goodwill resulting from acquisitions is capitalized. Further, under both sets of standards, goodwill is not amortized, but is tested for impairment armually. An impairment charge reduces net income and decreases the carrying value of goodwill to its actual value. Impairment of goodwill is a non-cash expense and therefore does not affect cash flows.


Goodwill can significantly affect the comparability of financial statements of companies. When performing ratio analysis, income statement values should be adjusted by removing impairment expense (so that operating trends can be identified), and balance sheet values should be adjusted by excluding goodwill when computing financial ratios. Analysts should evaluate future acquisitions of a company in light of the price paid relative to net assets and earnings prospects of the acquired company (economic goodwill).

Companies are required to disclose information that assists users in evaluating the nature and financial impact of business combinations. Information such as the purchase price paid relative to the fair value of a company's net assets and earnings prospects of the acquired company help analysts to develop expectations about the company's performance following an acquisition.

Financial assets Under IFRS, a financial instrument is defined as a contract that gives rise to a financial asset for one entity, and a financial liability or equity instrument for another entity.2 Financial assets include investments in securities (e.g., stocks and bonds) and receivables, while financial liabilities include bonds payable and notes payable. A derivative is a complex financial instrument that derives its value from some underlying factor (e.g., interest rate, exchange rate, underlying asset price) and requires little or no initial investment. As we shall learn later, derivatives may be used for hedging purposes or for speculation.

Mark-to-market is a process of adjusting the values of trading assets and liabilities to reflect their current market values. These adjustments are usually made on a daily basis. Assets that are classified as held for trading and available for sale are subject to markto-market adjustments. Exhibit 2-1 breaks down various marketable and non-marketable

financial instruments according to the measurement base used to value them.

Exhibit 2-1: Measurement Bases of Various Financial Assets3

Measured at Fair Value Measured at Cost or Amortized Cost

Financial Assets Financial Assets Financial assets held for trading Unlisted instruments. (stocks and bonds). Held-to-maturity investments. Available-for-sale financial assets Loans and receivables. (stocks and bonds). Derivatives. Non-derivative instruments with face value exposures hedged by derivatives.

2 - lAS 32, Financial Instruments: Presentation, paragraph 11. 3 - Exhibit 10, Volume 3, CFA Program Curriculum 2017.

©2017Wiley


Marketable investment securities can be classified under the following categories:

Available-for-sale securities: These are debt or equity securities that are neither expected to be traded in the near term, nor held till maturity. They may be sold to address the liquidity needs of the company. These securities are reported at fair market value on the balance sheet. While dividend income, interest income, and realized gains and losses on AFS securities are reported on the income statement, unrealized gains and losses are reported in other comprehensive income as a part of shareholders ' equity.

The "available-for-sale" classification no longer appears in IFRS as of20!0, even though "IFRS 9: Financial Instruments" will be effective from 2013. However, even though the available-for-sale category will not exist, IFRS will still pemtit certain equity investments to be measured at fair value with any unrealized gains and losses recognized in other comprehensive income. This classification will be known as financial assets measured at fair value through other comprehensive income.

Held-to-maturity securities: These are debt securities that are purchased with the intent of holding them till maturity. Held-to-maturity securities are carried at amortized cost (Amortized cost; Face value - Unamortized discount+ Unamortized premium). For these securities, unrealized gains or losses from changes in market value are ignored and not recognized on the financial statements. Only interest income and realized gains and losses (gains and losses when these securities are sold) are recognized on the income statement. See Exhibit 2-2.

Trading securities: These are debt and equity securities (e.g. , stocks and bonds) that are acquired with the intent of earning trading profits over the near term. These securities are measured at fair market value on the balance sheet. Dividend income, interest income, realized gains and losses, and unrealized gains and losses are all reported on the income statement.

Exhibit 2-2: Accounting for Gains and Losses on Marketable Securities

Held-to-Maturity Available-for-Sale Trading Securities Securities Securities

Balance Sheet Reported at cost or Reported at fair value. Reported at fair amortized cost. value.

Unrealized gains or losses due to changes in market value are reported in other comprehensive income.

Items recognized Interest income. Dividend income. Dividend income. on the income statement Realized gains and Interest income. Interest income.

losses. Realized gains and Realized gains and losses. losses.

Unrealized gains and losses due to changes in market value.

© 2017Wiley

Example 2-1 will help us understand the accounting of gains and losses on marketable securities under each of the different classifications.

Example 2-1: Marketable Securities


Panorama Inc. invests $5,000,000 in a 10% semiannual coupon fixed-income security. After six months, Panorama receives the first coupon payment of $250,000. Additionally, interest rates have declined over the period, and the value of the securities has increased by $1,000,000. lllustrate how ownership of this bond will affect Panorama's financial statements under each of the three classifications of marketable securities.

Solution

Balance Sheet

Assets Cash Cost of securities Uruealized gains (losses)

Liabilities

Equity Paid-in-capital Retained earnings Other comprehensive income

Income Statement Interest income Uruealized gains (losses)

Non-Current Liabilities

Trading $

250,000 5,000,000 1,000,000 6,250,000

5,000,000 1,250,000

6,250,000

250,000 1,000,000

1,250,000

Available for Sale

$

250,000 5,000,000 1,000,000 6,250,000

5,000,000

L~'~ ,000,000 ,250,000

250,000

250,000

Held to Maturity

$

250,000 5,000,000

5,250,000

5,000,000

L~'~ ,250,000

250,000

250,000

Non-current liabilities include the long-term financial liabilities and deferred tax liabilities.

Long-term financial liabilities These may either be measured at fair value or amortized cost. Exhibit 2-3 lists some financial liabilities along with their measurement basis.

©2017Wiley


Exhibit 2-3: Measurement Basis of Various Financial Liabilities

Measured at Fair Value Measured at Cost or Amortized Cost

Financial Liabilities Financial Liabilities Derivatives. All other liabilities (bonds payable and Financial liabilities held for trading. notes payable). Non-derivative instruments with face value exposures hedged by derivatives.

We shall study the accounting of financing liabilities in greater detail in Reading 31.

Deferred tax liabilities These usually arise when a company's income tax expense exceeds taxes payable. The company pays less taxes based on its tax return than it should pay according to its financial statements. These unpaid taxes will be paid in future periods and are therefore a liability for the company. Deferred tax liabilities have current and non-current portions. These items will be discussed in more detail in Reading 30.

LESSON 3: EQUITY

LOS 25f: Describe the components of shareholders' equity. Vol 3, pp 241-244

• +-U.S. GAAP and IFRS define equity as the owners' residual claim on the assets of an entity after deducting all liabilities. Various components of the owners ' equity are described below.

The first five comJXlnents represent equity attributable to owners of the parent company, while the sixth comp:rnent represents equity attributable to noncontrolling interests.

·-·-·-

Capital contributed by owners (common stock or issued capital): Owners contribute capital to an entity by investing in common shares. Common shares have par (stated) values that are required to be listed separately in owners ' equity. Required disclosures also include the number of authorized, issued, and outstanding shares for each class of stock issued by the company. Authorized shares are the maximum number of shares that can be sold under the company's Articles of Incorporation. Issued shares are the total number of shares that have been sold to shareholders. Outstanding shares equal the number of shares that were issued less the number of shares repurchased (treasury stock). Preferred shares: Preferred shareholders receive dividends (at a specified percentage of par value) and have priority over ordinary shareholders in the event of liquidation. Preferred shares may either be classified as equity or financial liabilities depending on their characteristics. For example, perpetual, nonredeemable preferred shares are classified as equity, while preferred shares with mandatory redemption are classified as financial liabilities. Treasury shares: These are shares that have been bought back by the company. Share repurchases result in a reduction in owners' equity and in the number of shares outstanding. These shares do not receive dividends and do not have voting rights. While Treasury shares may be reissued at a later date, no gain or loss is recognized when they are reissued. Retained earnings: These are the cumulative earnings (net income) of the firm over the years that have not been distributed to shareholders as dividends.

© 2017Wiley


Accumulated other comprehensive income: This represents cumulative other comprehensive income. Non-controlling interest (minority interest): This is the minority shareholders' pro rata share of the net assets of a subsidiary that is not wholly owned by the company.

Statement of Changes in Owners' Equity

This statement presents the effects of all transactions that increase or decrease a company's equity over the period. Under IFRS, the following information should be included in the statement of changes in equity:

Total comprehensive income for the period; The effects of any accounting changes that have been retrospectively applied to previous periods. Capital transactions with owners and distributions to owners; and Reconciliation of the carrying amounts of each component of equity at the beginning and end of the year.4

Under U.S. GAAP, companies are required to provide an analysis of changes in each component of stockholders'equity that is shown in the balance sheet. 5

Exhibit 3-1 provides an example of a typical statement of changes in stockholders' equity.

Exhibit 3-1: Statement of Changes in Shareholders' Equity

Abel Company Statement of Changes in Stockholders' Equity

Accumulated Retained Other

Common Earnings Comprehensive Total Stock$ $ Income$ $

Beginning balance 30,000 22,000 -3,000 49,000

Components of comprehensive income

Net income 4,000 4,000

Unrealized loss on AFS Securities -100 -100

Unrealized loss on cash flow hedge -150 -150

Minimum pension liability adjustment -75 -75

Translation adjustment 90 90

Comprehensive income 3,765

Issuance of common stock 3,000 3,000

Repurchases of common stock -8,000 -8,000

Dividends -2,500 -2,500

Ending balance 25,000 23,500 -3,235 45,265

4 - lAS I , Presentation of Financial Statements, paragraph 80. 5 - FASS ASC 505- IO-S99 [Equity-Overall-SEC materials] indicates that a company can present the analysis of changes in stockholders' equity in the notes or in a separate statement

© 2017Wiley @


Uses and Analysis of Balance Sheets

Analysts can gain information regarding a company's liquidity, solvency, and the economic resources controlled by the company by examining its balance sheet.

Liquidity refers to a company's ability to meet its short-term financial obligations. Solvency refers to a company's ability to meet its long-term financial obligations.

Two of the techniques that may be used to analyze a company's balance sheet are common-size analysis and ratio analysis.

LESSON 4: ANALYSIS OF THE BALANCE SHEET

LOS 25g: Convert balance sheets to common-size balance sheets and interpret common-size balance sheets. Vol 3, pp 246-254

LOS 25h: Calculate and interpret liquidity and solvency ratios. Vol 3, pg 254

Common-Size Balance Sheets

A vertical common-size balance sheet expresses each balance sheet item as a percentage of total assets. This allows an analyst to perform historical analysis (time-series analysis) and cross-sectional analysis across firms within the same industry.

Exhibit 4-1 illustrates the construction of a common-size balance sheet.

Exhibit 4-1: The Construction of a Common-Size Balance Sheet

ASSETS Current assets Cash and cash equivalents Short-term marketable securities

Accounts receivable Inventory Total current assets Property, plant, and equipment, net Intangible assets Goodwill

Total assets

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities Accounts payable

Total current liabilities Long-term bonds payable

Total liabilities Total shareholders' equity

Total liabilities and shareholders' eqnity

Company A ('000)

400

200 500

100 1,200

2,050 500

3,750

800 800

IO

810 2,940

3,750

CompanyB ('000)

3,000 1,300

1,000

300 5,600

2,650

1,000

9,250

600 600

8,500

9,100

ISO

9,250

©2017Wiley


Exhibit 4-1: (continued)

Company A CompanyB

ASSETS

Current assets Cash and cash equivalents

Short-term marketable securities

Accounts receivable

Inventory

Total current assets

Property, plant, and equipment, net

Intangible assets

Goodwill

Total Assets

LlABILITlES AND SllAREHOLDERS' EQUITY

Current liabilities

Accounts payable

Total current liabilities

Long-term bonds payable

Total liabilities

Total shareholders' equity

Total Liabilities and Shareholders' Equity

The following important points should be noted:

(%)

10.7%

5.3%

13.3%

2.7%

32.0%

54.7%

13.3%

0.0%

100.0%

21.3%

21.3%

0.3%

21.6%

78.4%

100.0%

(%)

32.4%

14.1%

10.8%

3.2%

60.5%

28.6%

0.0%

10.8%

100.0%

6.5%

6.5%

91.9%

98.4%

1.6%

100.0%

Company A has 16% of its assets in cash and short-term marketable securities, while Company B has 46.5% of its assets in cash and short-term marketable securities. Therefore Company B is more liquid than Company A. Company i'<s current liabilities exceed its cash on hand by $400,000. This means that Company A might need to raise cash through some other means (e.g., by selling inventory or collecting accounts receivable) to meet its short-term liabilities. On the other hand, Company B has sufficient cash on hand ($3 million) to meet its short-term liabilities ($600,000). The presence of goodwill on Company B's balance sheet shows that the company has grown via acquisitions. In contrast, Company A seems to have pursued a strategy of internal growth as evidenced by the lack of goodwill on its balance sheet. Company B has financed 98.4% of its total assets with liabilities. In contrast, Company A finances only 21.6% of its assets with liabilities. Therefore, Company A is more solvent than Company B. If Company B sees significant volatility in cash flows, it may struggle to meet its debt-servicing obligations.

©2017Wiley


Balance Sheet Ratios

These are ratios that have balance sheet items in the numerator and the denominator. The two main categories of balance sheet ratios are liquidity ratios, which measure a company's ability to settle short-term obligations, and solvency ratios, which evaluate a company's ability to settle long-term obligations.

The higher a company's liquidity ratios, the greater the likelihood that the company will be able to meet its short-term obligations.

Table 4-1: Liquidity Ratios

Current ratio Quick ratio (acid test ratio)

Cash ratio

Numerator

Current assets Cash + marketable securities

+ receivables Cash + marketable securities

Denominator

Current liabilities

Current liabilities

Current liabilities

Higher solvency ratios, on the other hand, are undesirable and indicate that the company is highly leveraged and risky.

Table 4-2: Solvency Ratios

Long-term debt-to-equity ratio

Debt-to-equity ratio

Total debt ratio

Financial leverage ratio

Numerator

Total long-term debt

Total debt

Total debt

Total assets

Denominator

Total equity

Total equity

Total assets

Total equity

Ratio analysis is covered in detail in Reading 27. We also discuss the uses and limitations ofratio analysis in that reading.

© 2017Wiley

UNDERSTANDING CASH FLOW STATEMENTS

READING 26: UNDERSTANDING CASH FL.ow STATEMENTS

LESSON 1: THE CASH FLOW STATEMENT: COMPONENTS AND FORMAT

LOS 26a: Compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of the items. Vol 3, pp 267-268

Under both IFRS and U.S. GAAP, cash flows are classified into the following categories (see Table 1-1):

Cash flow from operating activities (CFO): These are inflows and outflows of cash related to a firm's day-to-day business activities.

Cash flow from investing activities (CFI): These are inflows and outflows of cash generated from the purchase and disposal of long-term investments. Long-term investments include plant, machinery, equipment, intangible assets, and nontrading debt and equity securities.

Note: Investments in securities that are considered highly liquid (cash equivalents) are not included in investing activities. Neither are securities held for trading. Cash flows

associated with the purchase and sale of highly liquid cash equivalents and of securities for trading purposes are classified under cash flow from operating activities.

Cash flow from financing activities (CFF): These are cash inflows and outflows generated from issuance and repayment of capital (interest-bearing debt and equity).

Note: Indirect short·term borrowings from suppliers that are classified as accounts payable, and changes in receivables from customers are not considered financing activities; they are classified as operating activities.

Table 1-1: Cash Flow Classification Under U.S. GAAP

CFO

Inflows Cash collected from customers. Interest and dividends received. Proceeds from sale of securities held for trading.

CFI Inflows Sale proceeds from fixed assets. Sale proceeds from long-term investments.

CFF Inflows Proceeds from debt issuance. Proceeds from issuance of equity instruments.

Outflows Cash paid to employees. Cash paid to suppliers. Cash paid for other expenses. Cash used to purchase trading securities. Interest paid. Taxes paid.

Outflows Purchase of fixed assets. Cash used to acquire LT investment securities.

Outflows Repayment of LT debt. Payments made to repurchase stock. Dividends payments.

Note: There is a difference in how some cash flows are classified under IFRS and U.S. GAAP. These differences are discussed in LOS 26c and are very important from the examination perspective.

© 2017Wiley


LOS 26b: Describe how non-cash investing and financing activities are reported. Vol 3, pp 267-269

Noncash investing and financing activities are not reported on the cash flow statement because these transactions do not involve any receipt or payment of cash. Examples of noncash investing and financing activities include:

Barter transactions where one nonmonetary asset is exchanged for another. Issuance of common stock for dividends or when holders of convertible bonds or convertible preferred stock convert their holdings into ordinary shares of the company. Acquisition of real estate with financing provided by the seller.

Remember that companies are required to disclose any significant noncash investing and financing activities in a separate note or a supplementary schedule to the cash flow statement.

LOS 26c: Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP). Vol 3, pp 269-270

Cash flow statements prepared under IFRS and U.S. GAAP differ along the following lines:

Classification of cash flows: Certain cash flows are classified differently under IFRS and U.S. GAAP. IFRS offers more flexibility regarding the classification of certain cash flows. Presentation format: There is a difference in the presentation requirements for cash flow from operating activities.

Table 1-2 highlights important differences between IFRS and U.S. GAAP with respect to cash flow statements.

© 2017Wiley


Table 1-2: Cash Flow Statements: Differences Between IFRS and U.S. GAAP1

Topic

Classification of cash flows:

Interest received

Interest paid

Dividends received

Dividends paid

Bank overdrafts

Taxes paid

Format of statement

IFRS

Operating or investing

Operating or financing

Operating or investing

Operating or financing

Considered part of cash equivalents

Generally operating, but a portion can be allocated to investing or financing if it can be specifically identified with these categories

Direct or indirect; direct is encouraged

U.S.GAAP

Operating

Operating

Operating

Financing

Not considered part of cash and cash equivalents and classified as financing

Operating

Direct or indirect; direct is encouraged. A reconciliation of net income to cash flow from operating activities must be provided regardless of method used

LOS 26d: Distinguish between the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method. Vol 3, pp 270-280

Under both IFRS and U.S. GAAP, there are two acceptable formats for presenting the cash flow statement- the direct method and the indirect method. These methods differ only in the presentation of the CFO section of the cash flow statement; calculated values for CFO are the same under both. Further, the presentation of CFF and CFI are exactly the same under both formats.

Direct method: Under the direct method, income statement items that are reported on an accrual basis are all converted to cash basis. All cash receipts are reported as inflows, while cash payments are reported as outflows. Exhibit 1-1 illustrates the presentation of CFO under the direct method.

I - Sources: lAS 7; FASS ASC Topic 230; and "IFRS and U.S. GAAP: Similarities and Differences," PricewaterhouseCoopers (September 2009), available at www.pwc.com.

©2017Wiley

UNDERSTANDING CASH FLDW STATEMENTS

Exhibit 1-1

CompanyXYZ Cash Flow from Operating Activities Cash collected from customers Cash paid to suppliers Cash paid to employees Cash paid for interest Cash paid for taxes Operating cash flow

$100,000 (30,000) (12,000) (5,000) (3,000)

$50,000

Presentation of CFO under the direct method has similarities with the presentation of the income statement. The income statement starts with total sales and deducts direct and indirect costs to arrive at net income. The direct method of calculating CFO starts with cash sales and deducts all cash payments for direct and indirect costs to arrive at cash flow from operations.

Indirect method: Under the indirect method, cash flow from operations is calculated by applying a series of adjustments to net income. These adjustments are made for noncash items (e.g., depreciation), nonoperating items (e.g., gains on sale of noncurrent assets), and changes in working capital accounts resulting from accrual accounting. Exhibit 1-2 illustrates the presentation of CFO under the indirect method.

Exhibit 1-2

Company ABC Cash Flow from Operating Activities Net income Adjustments: Depreciation Gain on sale of machinery Increase in inventory Decrease in accounts receivable Decrease in accounts payable Operating cash flow

The Direct Method Versus Indirect Method

$120,000

10,000 (1 ,000) (2,000) 3,000

(1 ,000) $129,000

The direct method explicitly lists the actual sources of operating cash inflows and outflows, whereas the indirect method only provides net results for these inflows and outflows. The argument is similar to the one for having an income statement that lists all revenue and expense items, as opposed to one that only provides the end result (i.e. , net income). The information provided in the direct format is very useful in evaluating past performance and making projections of future cash flows. The indirect method provides a list of items that are responsible for the difference between net income and operating cash flow. These differences can then be used when estimating future operating cash flows. The indirect method facilitates forecasting of future cash flows since forecasts of future net income simply have to be adjusted for changes in balance sheet accounts that are caused by differences between accrual and cash accounting.

©2017Wiley


LESSON 2: THE CASH FLOW STATEMENT: LINKAGES AND PREPARATION

LOS 26e: Describe how the cash flow statement is linked to the income statement and the balance sheet. Vol 3, pp 280-294

Links Between the Cash Flow Statement and the Income Statement and Balance Sheet

The sum of cash flow from operating, investing, and financing activities equals the change in cash over the year.

CFO + CFI + CFF = Change in cash Year-end cash balance - Beginning-of-year cash balance= Change in cash

Operating income and expense items are recognized on the income statement on an accrual basis, which means that revenues and expenses are recognized when incurred, irrespective of when the associated cash flows occur. When the timing of an expense or revenue item differs from the associated cash flow, it is reflected in changes in balance sheet accounts. For example, if revenue is recognized prior to the receipt of cash, accounts receivable will increase.

Beginning accounts receivable + Revehues - Cash received from customers L = Ending accounts receivable

If an expense is incurred but not paid for, it is charged on the income statement and accounts payable increase.

Beginning accounts payable+ Purchases - Cash paid to suppliers

Previous year's balance sheet

Current year's balance sheet


Current year's income statement

Current year's cash flow statement

= Ending accounts payable Purchases "' COGS ~----------------- 1 + Ending inventory

Beginning inventory

These changes in current assets and current liabilities are then used to reconcile net income to operating cash flows under the indirect method.

CFI is calculated from changes in asset balances under the noncurrent assets section of the balance sheet.

CFF is calculated from changes in the equity and noncurrent debt sections of the balance sheet.

A company's retained earnings (on the balance sheet) represent cumulative net income that has not been distributed to shareholders. Every year, if the company makes a profit, some of it may be distributed to shareholders as dividends, while the rest is added to retained earnings.

I Beginning retained earnings+ Net income - Dividends declared = Ending retained earnings. I

~----------• I

Understanding these links between the balance sheet, income statement, and statement of cash flows facilitates the evaluation of a company's financials and the detection of accounting irregularities.

© 2017Wiley



LOS 26f: Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data. Vol 3, pp 280--294

Sources Versus Uses of Cash

Let's consider an asset account, inventory.

If inventory levels have increased from the previous year, more liquidity of the firm is tied up in inventories. This is a use of cash for the firm. If inventory levels have decreased over the year, less of the firm's cash is tied up in inventory. This is a source of cash for the firm.

Increases in current assets are uses of cash and decreases in current assets are sources of cash. Changes in asset balances and cash are negatively related.

Now let's move on to a liability account, accounts payable.

If the total amount due to the firm's creditors has increased over the year, it implies that the firm has borrowed more money. This represents a source of cash to the firm. If the amount payable to creditors has fallen over the year, some creditors have been paid back, which is a use of cash for the firm.

Increases in current liabilities are sources of cash, while decreases in current liabilities are uses of cash. Changes in liability balances and cash are positively related.

The Direct Method Step I: Start with sales on the income statement. Go through each income statement account and adjust it for changes in related working capital accounts on the balance sheet. This serves to remove the effects of the timing difference between the recognition of revenues and expenses and the actual receipt or payment of cash.

Step 2: Determine whether changes in these working capital accounts indicate a source or use of cash. Make sure you put the right sign in front of the income statement item. Sales are an inflow item so they have a positive effect on cash flow, while COGS, wages, taxes, and interest expense are all outflow items that have negative effects on cash flow.

Step 3: Ignore all nonoperating items (e.g., gain/loss on sale of plant and equipment) and noncash charges (e.g., depreciation and amortization).

The Indirect Method Step I: Start with net income. Go up the income statement and remove the effects of all noncash expenses and gains from net income. For example, the negative effect of depreciation is removed from net income by adding depreciation back to net income. Cash-based net income will be higher than accrual-based net income by the amount of noncash expenses.

Step 2: Remove the effects of all nonoperating activities from net income. For example, the positive effect of a gain on sale of fixed assets on net income is removed by subtracting the gain from net income.

Step 3: Make adjustments for changes in all working capital accounts. Add all sources of cash (increases in current liabilities and declines in current assets) and subtract all uses of cash (decreases in current liabilities and increases in current assets).

© 2017Wiley


The income statement and balance sheet for ABC Company are presented below. We will use these statements to construct the cash flow statement for the company using the direct and indirect methods.

INCOME STATEMENT LEGEND Year ended Dec 31 2008 Amounts used in calculating . are filled with color.

Revenues 23,000 Amounts used in calculating CFI are written in color.

Cost of goods sold 11,500 Amounts used in calculating ~ are boxed in color.

Gross profit 11,500 Salary and wages expense 4,000

Depreciation expense Other operating expenses 3,500 Total operating expenses 8,500 Operating profit 3,000 Other revenues (expenses)

Gain on sale of equipment Interest expense (300) Income before tax 2,900 Income tax expense J.!AQQl Net income 1,500

BALANCE SHEET As at Dec 31 2008

Net 2008 2007 Change

Cash 2,300 1,150 1,150

Accounts receivable 1,000 950 -Inventory 3,900 3,250 -Prepaid expenses 100 250 -) Total current assets 7,300 5,600 1,700 Land 500 500 Buildings 3,600 3,600 Equipment 7,700 8,500 (800) Less accumulated depreciation (3,400) (2,900) 500

Total long-term assets 8,400 9,700 (1,300) Note: The book value

Total assets 15,700 15~00 400 of the equipment sold was $300.

Accounts payable 3,500 3,300 -Salary and wages payable 80 70 10 Interest payable 60 85 (25)

Income tax payable 60 45 15

Other accrued liabilities 1,200 1,100

Total current liabilities 4,900 4,600 300 Long-term debt 3,000 3,600 1(600)1 Common stock 4,550 4,850 IC300l l Retained earnings 3,250 2,250 [tQP_Q] Total liabilities and equity 15,700 15~00 400

©2017Wiley @


Accounts receivable is an asset.An increase in an asset isa use of cash.

The Direct Method to Compute CFO

Total sales adjusted for changes in related working capital accounts are known as 1 cash collections from customers: '---~~~---' I

Sales result in an inflow of cash so we put a positive sign before the sales figure

Accounts payable is a liability.An increase in liability isasourceofcash

COGS, salaries, wages, taxes, interest expense, and other expenses are outflows of cash, so we put a negative sign before them.

Cash collections = Sales - Increase in accounts receivable= t 23,000 - = $22,950

Cost of goods sold adjusted for changes in related working capital items is known as cash payments to suppliers:

Cash paid to suppliers = -COGS - Increase in inventory + Increase in A/C payable = -11 ,500 - • + • = -$11,950

Salaries and wages adjusted for related working capital accounts:

Cash salaries and wages= -Wages and salaries+ Increase in wages and salaries payable = -4,000 + IO = -$3,990

Depreciation is a noncash expense so it is ignored altogether.

Other operating expenses adjusted for changes in related working capital accounts:

Other operating expenses (cash)= -Other operating expenses (accrual basis)+ Decrease in prepaid expenses + Increase in other accrued liabilities

= -3 ,500 +. +. = -$3,250

Gain on sale of equipment relates to the sale of a long-lived asset. The proceeds from this transaction are classified under investing activities and ignored in the calculation of CFO.

Interest expense adjusted for related working capital accounts:

Cash interest paid= -Interest expense - Decrease in interest payable = -300 - 5 = -$325

Income tax expense adjusted for related working capital accounts:

Cash taxes paid= -Income tax expense +Increase in taxes payable = -1,400 + 15 = -$1,385

Cash flow from operating activities under the direct method:

Cash received from customers Cash paid to suppliers Cash paid to employees Cash paid for other operating expenses Cash paid for interest Cash paid for income taxes

Net cash flow from operating activities

22,950 -11,950

-3,990 -3,250

-325 -1,385

© 2017Wiley


Calculating - Using the Indirect Method:

On the income statement, the only noncash expense is depreciation expense of $1,000, and the only nonoperating income/expense is the gain on sale of equipment of $200. We start by removing the effects of these two items from net income:

Net income 1,500 Add: Depreciation expense

Less: Gain on sale of equipment -2,300

Next, we adjust the figure calculated above for changes in all working capital accounts, adding sources of cash and subtracting uses of cash.

Increase in accounts receivable (use)

Increase in inventory (use)

2,300 --Decrease in prepaid expenses (source)

Increase in accounts payable (source) --Increase in salaries and wages payable (source)

Decrease in interest payable (use)

IO

-2 15 Increase in income tax payable (source)

Increase in accrued liabilities (source) -Net cash flow from operating activities -Notice that we obtain the same answer for CFO under both methods.

Exhibit 2-1: Adjustments to Net Income Using the Indirect Method

Additions

©2017Wiley

Noncash items o Depreciation expense of tangible assets

Amortisation expense of intangible assets Depletion expense of natural resources Amortisation of bond discount

Nonoperating losses o Loss on sale or write-down of assets o Loss on retirement of debt o Loss on investments accounted for under the equity

method Increase in deferred income tax liability Changes in working capital resulting from accruing higher amounts for expenses than the amounts of cash payments or lower amounts for revenues than the amounts of cash receipts

o Decrease in current operating assets (e.g., accounts receivable, inventory, and prepaid expenses)

o Increase in current operating liabilities (e.g. , accounts payable and accrued expense liabilities)

(Exhibit continued on next page ... )


The historical cost and accumulated depreciation of a long-lived asset is removed from the balance sheet once it is sold.


Subtractions

Calculating CFI and~:

Noncash items (e.g., amortisation of bond premium) Nonoperating items

o Gain on sale of assets o Gain on retirement of debt o Income on investments accounted for under the

equity method Decrease in deferred income tax liability Changes in working capital resulting from accruing lower amounts for expenses than for cash payments or higher amounts for revenues than for cash receipts

o Increase in current operating assets (e.g., accounts receivable, inventory, and prepaid expenses)

o Decrease in current operating liabilities (e.g., accounts payable and accrued expense liabilities)

Calculating cash flow from investing activities requires us to consider the effects of transactions relating to long-lived assets and long-term investments on cash.

Before we get into calculating cash flow from investing activities, let's go through some fundamental accounting:

The value of gross fixed assets indicates the historical cost of the fixed assets owned by the company at the balance sheet date. If the figure for gross fixed assets changes from one year to the next, there has been an investing activity. If gross fixed assets increase, there has been a fixed asset purchase, and if gross fixed assets decrease, there has been a fixed asset disposal.

Beginning gross fixed assets + Purchase price of new fixed assets - Historical cost of disposed fixed assets = Ending gross fixed assets.

Net fixed assets equal gross fixed assets minus accumulated depreciation.

Going back to our example, the gross amounts recorded for land and for buildings are the same across both years ($500 and $3,600, respectively). Therefore, we conclude that there have been no purchases or sales of land and buildings during the year.

However, the gross amount recorded for equipment has decreased by $800. This suggests that there has been a sale of equipment over the year. Our belief is confirmed by the fact that the company also recognized a gain of sale of equipment on its income statement.

Calculation of historical cost of sold equipment:

Beginning gross fixed assets + Purchase price of new fixed assets - Historical cost of disposed fixed asset = Ending gross fixed assets.

$8,500 + 0 - Historical cost of sold equipment = $7, 700

Historical cost of sold equipment = $800

©2017Wiley


Calculation of accumulated depreciation on sold equipment:

Beginning accumulated depreciation+ Current year's depreciation on all assets -Accumulated depreciation on sold asset = Ending accumulated depreciation.

$2,900 + $1 ,000 -Accumulated depreciation on sold equipment= $3,400

Accumulated depreciation on sold equipment = $500

Calculation of book value of sold equipment:

Book value of sold equipment= Historical cost - Accumulated depreciation

Book value of sold equipment= $800 - $500 = $300

Calculation of proceeds from sale of equipment:

Selling price - Book value = Gain/loss on sale of equipment

Selling price - $300 = -

Cash proceeds from the sale of equipment equal $500. These proceeds are classified as inflows from investing activities.

Cash How from investing activities:

Cash received from sale of equipment Net cash How from investing activities

Calculating [g<]j

500 500

Cash How from financing activities is generated from the issuance and repayment of capital (long-term debt and equity) and distributions in the form of dividends to shareholders.

Long-term debt: An increase in long-term debt from one year to the next implies cash inflows from new borrowings. A decrease implies debt repayment and an outflow of cash.

Over the course of the year, ABC's long-term debt fell by~- This implies that $600 was used by the company to retire debt.

Equity: An increase in common stock from one year to the next implies cash inflows from issuance of new shares. A decrease implies a share repurchase that results in a cash outflow.

ABC has repurchased 1$3001 of common stock over the year, which reduces cash flow from financing activities.

Dividends: Cash dividends paid out can be computed from the following relationship:

Cash dividends paid out = Beginning dividends payable + Dividends declared -Ending dividends payable.

Dividends declared = Beginning retained earnings + Net income - Ending retained earnings.

©2017Wiley


Notice that ABC's retained earnings increased by only $1,000 even though income was $1,500. This implies that $500 of net income was appropriated to the company's shareholders as dividends. Even though our example never explicitly mentions dividends, we must ensure that net income reconciles with the change in retained earnings. ABC declared $500 of dividends and paid them out as well. If the company had not paid them, we would have seen an increase in dividends payable of $500 over the year.

Cash flow from financing activities

Cash paid to retire long-term debt

Repurchase of common stock

Cash paid as dividends

Net cash flow from financing activities

I -6001 I -3ool

-500

E!>@

Combining the effects of CFO, CFI, and CFF gives us change in cash and cash equivalents over the year:

Net cash provided by operating activities Net cash provided by investing activities Net cash used for financing activities Net change in cash over the year

500 I -1,400 I

1,150

The net increase in cash on the cash flow statement must equal the difference between the cash balances for 2007 and 2008. The company's cash balance in 2007 was $1 ,150, and in 2008 was $2,300. Notice that the difference between the two amounts ($1,150) is also the net increase in cash calculated on the cash flow statement.

LOS 26g: Convert cash flows from the indirect to the direct method. Vol 3, pp 293-294

There is a three-step process for converting an indirect cash flow statement into a direct statement.

Step I: Aggregate all revenues and all expenses

Aggregate all operating and nonoperating revenues and gains such as sales and gains from sale of assets. Aggregate all operating and nonoperating expenses such as wages, depreciation, interest, and taxes.

Step 2: Remove the effect of noncash items from aggregated revenues and expenses and separate the adjusted revenues and expenses into their respective cash flow items.

Deduct noncash revenue items such as gain on sales of assets from total revenue. Deduct noncash expense items such as depreciation from total expenses. Break down the adjusted expenses into cash outflow items, such as cost of goods sold, wages, interest expense, and tax expense.

© 2017Wiley


Step 3: Convert the accrual-based items into cash-based amounts by adjusting for changes in corresponding working accounts.

An increase (decrease) in an asset account is a cash outflow (inflow). An increase (decrease) in a liability account is a cash inflow (outflow).

Convert revenue into cash receipts from customers by adjusting for accounts receivable and unearned revenue. Convert COGS into cash payments to suppliers by adjusting for inventory and accounts payable. Convert wages, interest, and tax expenses into cash amounts by adjusting for wages payable, interest payable, taxes payable, and deferred taxes.

Conversion from Indirect to the Direct Method

Step 1

Aggregate all revenue and all expenses:

Total revenues (23,000 + 200) Total expenses (11,500 + 8,500 + 300 + 1,400) Net income

Step2

$23,200 $21,700

$1,500

Remove all noncash items from aggregated revenues and expenses and break out remaining items into relevant cash flow items:

Total revenue less noncash item revenues: (23,200 - 200)

Total expenses less noncash item expenses: (21,700 - 1,000)

Cost of goods sold Salary and wage expenses Other operating expenses Interest expense Income tax expense Total

Step3

$23,000

$20,700

$11,500 $4,000 $3,500

$300 $1,400

$20,700

Convert accrual amounts to cash flow amounts by adjusting for working capital changes:

Cash received from customers Cash paid to suppliers Cash paid to employees Cash paid for other operating expenses Cash paid for interest Cash paid for income tax

CFO

©2017Wiley

$22,950 ($11,950)

($3,990) ($3,250)

($325) ($1,385) $


LESSON 3: CASH FLOW STATEMENT ANALYSIS

LOS 26h: Analyze and interpret both reported and common-size cash flow statements. Vol 3, pp 296-302

Cash flow analysis helps us evaluate how well a business is being run and to estimate its future cash flows. The analysis begins with understanding the sources and uses of cash and determining which components of the cash flow statement these sources and uses can be attributed to. The analysis also includes an evaluation of the determinants of each of the components.

Major Sources and Uses of Cash

Sources and uses of cash depend upon the company's stage of growth.

Companies in the early stages of growth may have negative operating cash flows as cash is used by the company to finance inventory rollout and receivables. These negative operating cash flows are supported by financing inflows from issuance of debt or equity. Inflows of cash from financing activities are not sustainable. Over the long term, a company must generate positive cash flows from operating activities that exceed capital expenditures and payments to providers of debt and equity capital. Companies in the mature stage of growth usual! y have positive cash flows from operating activities. These inflows can be used for debt repayment and stock repurchases. They can also be used by the company to expand its scale of operations (investing activities).

Operating Cash Flow Changes in relevant asset and liability accounts should be used to determine whether business operations are a source or use of cash. Operating cash flow should be compared to net income. If high net income is not being translated into high operating cash flow, the company might be employing aggressive revenue recognition policies. Companies should ideally have operating cash flows that exceed net income. The variability of operating cash flow and net income is an important determinant of the overall risk inherent in the company.

Investing Cash Flow Changes in long-term asset and investment accounts are used to determine sources and uses of investing cash flows. Increasing outflows may imply capital expenditures. Analysts should then evaluate how the company plans to finance these investments (i.e., with excess operating cash flow or by undertaking financing activities).

Financing Cash Flow Changes in interest-bearing debt and equity are used to determine sources and uses of financing cash flow. If debt issuance contributes significantly to financing cash flow, the repayment schedule must be considered. Increasing use of cash to repay debt, repurchase stock, or make dividend payments might indicate a lack of lucrative investment opportunities for the company.

© 2017Wiley

Common-size analysis: There are two ways to construct common-size cash flow statements:


1. Express each item as a percentage of net revenues. This is the most commonly used format.

2. Express each cash inflow item as a percentage of total cash inflows, and each cash outflow item as a percentage of total cash outflows.

Common-size cash flow statements make it easier to identify trends in cash flows, and help in forecasting future cash flows as individual items are expressed as a percentage of revenues.

Exhibit 3-1 contains Rhodson Company's common-size cash flow statement:

Exhibit 3-1: Common-Size Cash Flow Statement

Rhodson Company

Cash Flow Statement

Percent of Revenues

Net income

Depreciation

Increase in accounts receivable

Increase in inventory

Decrease in prepaid expenses

Increase in accrued expenses

Operating cash flow

Cash from sale of fixed assets

Purchase of plant and equipment

Investing cash flow

Sale of bonds

Cash dividends

Financing cash flow

Total cash flows

Net revenue in 2008; $300,000 Net revenue in 2007; $250,000

Brief Analysis

2008

$ 55,000

10,000

- 5,000

- 3,000

1,500

2,000

60,500

12,000

- 10,000

2,000

7,500

- 2,000

5,500

68,000

2008

%

18.33

3.33

- 1.67

- 1.00

0.50

0.67

20.17

4.00

- 3.33

0.67

2.50

--0.67

1.83

22.67

CFO has fallen as a percentage of revenues in 2008.

2007

$ 45,000

10,000

-4,000

- 2,000

3,000

2,500

54,500

5,000

0

5,000

5,000

- 2,000

3,000

62,500

CFI is lower in 2008 due to the purchase of plant and equipment.

2007

%

18.00

4.00

- 1.60

--0.80

1.20

1.00

21.80

2.00

0.00

2.00

2.00

- 0.80

1.20

25.00

CFF has contributed more significantly to total cash flow in 2008. The company has issued more debt. Total cash flow has decreased as a percentage of sales.

©2017Wiley


LOS 26i: Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios. Vol 3, pp 302-305

Free cash flow is the excess of a company's operating cash flows over capital expenditure undertaken during the year. Free cash flow to the firm and free cash flow to equity are more precise measures of free cash flow as they identify specifically whom the cash is available to.

Free cash flow to the firm (FCFF) is cash that is available to equity and debt holders after the company has met all its operating expenses and satisfied its capital expenditure and working capital requirements.

FCFF =NI+ NCC+ [Intx (I-tax rate)]- FCinv-WCinv

where: NI = net income NCC = noncash charges FCinv =fixed capital investment (net capital expenditure) WCinv = working capital investment Int= Interest expense

Notice that net income that has been adjusted for noncash charges and changes in working capital accounts equals the company's operating cash flows. Therefore:

[ FCFF =CFO+ [Int x (I - tax rate)]- FCinv [

Example 3-1: Calculating FCFF

Continuing from our previous example of ABC Company and assuming a tax rate of 40%, calculate FCFF.

Solution

Recall the following information regarding ABC Company: CFO= $2,050 Interest expense = $300 Fixed capital investment = -$500 (the company sold noncurrent assets for $500)

Therefore:

FCFF =CFO+ Interest expense (I -Tax rate) - FCinv

FCFF = 2,050 + 300 (I - 0.4) - (-500) = $2,730

Note: Under IFRS, if the company has classified interest and dividends received as investing activities, they should be added to CFO to determine FCFF. If dividends paid were deducted from CFO, they should be added back to CFO to calculate FCFF. Dividends must not be adjusted for taxes as dividends paid are not tax-deductible.

©2017Wiley


Free cash flow to equity (FCFE) refers to cash that is available only to common shareholders.

I FCFE = CFO - FC!nv +Net borrowing I

Example 3-2: Calculating FCFE

Continuing from our previous example of ABC Company and assuming a tax rate of 40%, calculate FCFE.

Solution

Recall the following information regarding ABC Company: CFO= $2,050 Fixed capital investment= - $500 (the company sold noncurrent assets for $500) Net borrowing= - $600 (the company repaid $600 worth of debt)

Therefore:

FCFE =CFO - FCinv +Net borrowing

FCFE = 2,050 - (- 500) + (-600) = $1,950

A positive FCFE suggests that the company has operating cash flows available after payments have been made for capital expenditure and debt repayment. This excess belongs to common shareholders.

Note: Under IFRS, if the company has deducted dividends paid in calculating CFO, dividends must be added back to calculated FCFE.

Cash Flow Ratios

The information available on cash flow statements can be used to compute cash flow ratios. These ratios, like income statement and balance sheet ratios, can be used for comparing the company's performance over time (time-series analysis) or against other companies within the same industry (cross-sectional analysis). Cash flow ratios can be categorized as performance (profitability) ratios and coverage (solvency) ratios. See Table 3-1.

©2017Wiley


Table 3-1: Cash Flow Ratios2

Performance Ratio

Cash flow to revenue

Cash return on assets

Cash return on equity

Cash to income

Cash flow per share

Coverage Ratios

Debt coverage

Interest coverage

Reinvestment

Debt payment

Dividend payment

Formula

CFO I Net revenue

CFO I Average total assets

CFO I Average shareholders' equity

What it Measures

Cash generated per unit of revenue.

Cash generated from all resources, equity, and debt.

Cash generated from owner resources.

CFO I Operating income The ability of business operations to generate cash.

(CFO - Preferred dividends) I Operating cash flow available for each Number of common shares shareholder. outstanding

Formula What it Measures

CFO I Total debt Leverage and financial risk.

(CFO + Interest paid +Taxes Ability to satisfy interest obligations. paid) I Interest paid

CFO I Cash paid for long-term Ability to buy long-term assets with assets operating cash flows.

CFO I Cash paid for long-term Ability to meet debt obligations with debt repayment operating cash flows.

CFO I Dividends paid Ability to make dividend payments with operating cash flows.

Investing and financing CFO I Cash outflows for investing and financing activities

Ability to buy long-term assets, settle debt obligations and make dividend payments from operating cash flows.

2 - Exhibit 15, Volume 3, CPA Program Curriculum 2017

© 2017Wiley

FINANCIAL ANALYSIS TECHNIQUES

READING 27: FINANCIAL ANALYSIS TECHNIQUES

LESSON 1: ANALYTICAL TOOLS AND TECHNIQUES

Financial statement analysis applies analytical tools to financial statements and related data to make investment decisions. It involves transforming accounting data into information useful for analysis, forecasting, and decision-making.

Financial statement analysis reduces reliance on hunches and guesses in decision-making. It does not lower the need for expert judgment, but provides an effective and systematic basis for making investment decisions.

It is important for an analyst to understand the financial analysis process. A general framework for financial statement analysis is presented in Exhibit 1-1.

Exhibit 1-1: Framework for Financial Statement Analysis

I. Articulate the purpose

and the context of

the analysis.

Output: Adjusted financial statements Common-size statements Ratios and graphs Forecasts

4. Analyze/ interpret the processed

data.

Output: Analytical results

5~0~;:~i~a':d - I 6. Follow up. 1 conclusions.

The primary focus of this reading is on Steps 3 and 4, processing and analyzing data.

LOS 27a: Describe the tools and techniques used in financial analysis, including their uses and limitations. Vol 3, pp 322-338

A ratio expresses a mathematical relationship between two quantities in terms of a percentage or a proportion. Ratios may be computed using data directly from companies' financial statements or from other available databases. Computation of a ratio is a simple arithmetic operation but its interpretation may not be that simple. To be meaningful, a ratio must refer to an economically important relation.

The value of ratio analysis lies in its ability to assist an equity or credit analyst in the evaluation of a company' s past performance, assessment of its current financial position, and forecasting its future cash flows and profitability trends.

Uses of Ratio Analysis

Financial ratios provide insights into:

Microeconomic relationships within the company that are used by analysts to project the company's earnings and cash flows. A company 's financial flexibility. Management' s ability. Changes in the company and industry over time. How the company compares to peer companies and the industry overall.

©2017Wiley


@)

Common-Size Analysis

Common-size statements allow analysts to compare a company's performance with that of other firms and to evaluate its performance over time.

Common-Size Income Statements

A common-size income statement expresses all income statement items as a percentage of revenues. Common-size income statements are extremely useful in identifying trends in costs and profit margins. Further, certain financial ratios are explicitly stated on these statements (e.g., the gross profit margin and the net profit margin).

Income statement account Vertical common-size income statement percentage= Revenue X 100

Common-Size Balance Sheets

Common-size balance sheets express each item as a percentage of total assets. Commonsize balance sheets are prepared to highlight changes in the mix of assets, liabilities, and equity.

Balance sheet account Vertical common-size balance sheet percentage= Total assets X 100

Exhibit 1-2 contains the income statement and balance sheet of XYZ Company in terms of dollar amounts and common-size percentages.

Exhibit 1-2: Vertical Common-Size Income Statement and Balance Sheet for XYZ

Income Statement

2006 2006 2007 2007 $ % $ %

Sales 400,000 100.0 475 ,000 100.0

Cost of goods sold (COGS) 320,000 80.0 377,625 79.5

Gross profit 80,000 20.0 97,375 20.5

Selling, general, & administrative 28,000 7.0 30,875 6.5 ~ expenses (SG&A)

Depreciation 20,000 5.0 7,125 1.5 m Interest expense 20,000 5.0 33 ,250 7.0 @]

68,000 71 ,250

Profit before taxes 12,000 3.0 26,125 5.5

Income taxes (30% of pretax profits) 3,600 0.9 7,838 1.7

Net income 8,400 2.1 18,288 3.9 IIl

© 2017Wiley



Balance Sheet

2006 2006 2007 2007

$ % $ %

Assets

Current Assets

Cash 21,000 10,000 lfil Short-term investments 15,000 5 12,000 4

Accounts receivable 27,000 10 34,000 11

Inventories 44,000 16 33,000 11

Prepaid expenses 2,500 3,500

Other current assets 19,000 7 24,000

Total Current Assets 128,500 46 116,500 39 [§]

Fixed Assets

Net property and equipment 110,000 40 110,000 37

Long-term investments 10,000 4 4,000 1

Intangible assets 16,000 6 56,000 19 l2l Other long-term assets 12,000 4 12,000 4

Total Fixed Assets 148,000 54 182,000 61

Total Assets 276,500 100 298,500 100

Liabilities

Current Liabilities

Accounts payable 27,000 10 20,000 7

Accrued expenses 12,700 5 17,000 6

Total Current Liabilities 39,700 14 37,000 12

Long Term Debt 21,800 21,800 7 w Shareholders Equity

Common stock 120,000 43 135,000 45

Accumulated other comprehensive income 500 0 -300 0

Retained earnings .

95,000 34 100,000 34

Other equity -500 0 5,000 2

Total Shareholders' Equity 215,000 78 239,700 80

Total Liabilities and Shareholders' Equity 276,500 100 298,500 100

*The company paid out $13,288 in dividends for the year 2007.

©2017Wiley @)

FINANCIAL AN ALYS IS TECHNIQUES

Analysis of the common-size income statement for ABC Company indicates that:

1. The profitability of the company has improved. 2. Decrease in COGS and SG&A as a percentage of sales only explain a small

proportion of the improvement in profit margins. 3. Reduction in depreciation has contributed significantly to the improvement in

profitability. 4. The drastic reduction in depreciation has masked the effect of a significant increase

in interest expense over the period. 5. Interest expense has risen despite the fact that the long-term liabilities of the

firm have remained constant. This tells us that the company has probably issued floating-rate bonds and is now paying a higher effective interest rate on its loans.

6. Although the income statement shows improved profitability, the firm might run into some cash flow issues going forward. Higher interest expense has drained cash from the firm. On the income statement, the effect of higher interest expense is offset by significantly lower depreciation. While it helps reported profits, lower depreciation does not bring in any cash.

7. The company' s intangible assets now form a more significant proportion of its total assets. These must be scrutinized in detail.

8. More of the company's assets are now concentrated in long-term assets. Current assets ' share of total assets has declined significantly.

While common-size analysis does not tell us the entire story behind the company's financials, it does lead us in the right direction and prompt us to ask relevant questions in assessing the company's operating performance over the period, and evaluating its prospects going forward.

Cross-Sectional Analysis

Cross-sectional analysis, also known as relative analysis, compares a specific metric for one company with the same metric for another company or group of companies over a period of time. This allows comparisons even though the companies might be of significantly different sizes and/or operate in different countries. Consider two companies from the same industry. If one of them has accounts receivable representing 20% of its total assets, while the other has 40% of its assets in the form of accounts receivable, we might conclude that the latter has a greater proportion of credit sales or that it uses aggressive accounting policies for revenue recognition.

Trend Analysis

Trend analysis provides important information about a company's historical performance. It can also offer assistance in forecasting the financial performance of a company. When looking for trends over time, horizontal common-size financial statements are often prepared. Dollar values of accounts are divided by their base-year values to determine their common-size values. Horizontal common-size statements can also help identify structural changes in the business.

©2017~1ey

Example 1-1: Relationships Among Financial Statements

Consider the following information:

2011 ($) 2010 ($) 2009 ($)

Revenue 7,604,186 6,336,822 5,510,280

Net income 1,260,477 1,008,381 826,542

Operating cash How 942,258 1,046,953 1,102,056

Total assets 10,637,596 7,879,700 6,061,308

Based on the given information, comment on the financial performance of the company.

Solution

We can use horizontal common-size analysis to evaluate the financial performance of the company. The year-on-year percentage changes for various financial variables are calculated below:

2011 2010

Revenue 20.00% 15.00%

Net income 25.00% 22.00%

Operating cash How -10.00% -5.00%

Total assets 35.00% 30.00%

The percentage growth figures allow us to draw the following conclusions:

Net income is growing/aster than revenue. This indicates increasing profitability. However, the analyst should dig deeper and identify the source of this higher net income (i.e., whether it results from continuing operations, or from nonoperating, nonrecurring items). The company's operating cash flow is decreasing. This is a cause for concern and requires further investigation. The fact that operating cash flow is declining in spite of the positive growth in revenues may indicate a problem with the company's earnings quality (e.g., aggressive recognition of revenue). Total assets are growing faster than revenue. This suggests that the company's efficiency levels are declining. The analyst should look to identify the reason for the high growth rate in assets and also examine the composition of the increase in assets.

Uses of Charts in Financial Analysis

Graphs facilitate comparisons of firm performance and financial structure over time, highlighting changes in significant aspects of business operations. They may also be used to communicate important conclusions of financial analysis.

Pie charts are most useful in illustrating the composition of a total value. For example, a pie chart should be used when presenting the components of total expenses for the year (COGS, SG&A, depreciation).

©2017Wiley



Line graphs help identify trends and detect changes in direction or magnitude. For example, a line graph that illustrates a marked increase in accounts receivable while cash balances are falling indicates that the firm might have problems managing its working capital going forward.

A stacked common graph illustrates the changes in various items over the period in graphical form. Figure 1-1 illustrates the asset mix of Bilan Company. It is quite clear from this graph that while total assets are generally increasing over the 5-year period, an increasing proportion of the company's assets are composed of receivables.

Figure 1-1: Stacked Column Graph

A""ts $million

500

450

400

350

300

250

200

150

100

50

2005 2006 2007 y .. ..,

2008 2009

- Net noncurrent assets

~ Inventories

~ Receivables

~ Short-term investments

Bank and cash

Regression analysis can help identify relationships between variables (e.g., between sales and inventory) over time and assist analysts in making forecasts (e.g., the relationship between GDP and sales can be used to make revenue forecasts).

Limitations of Ratio Analysis Companies may have divisions that operate in different industries. This can make it difficult to find relevant industry ratios to use for comparisons. One set of ratios may suggest that there is a problem, but another set may indicate that the potential problem is only short term. There are no set ranges within which particular ratios for a company must lie. An analyst must use her own judgment to evaluate the implications of a given value for a ratio. This usually involves examining the operations of a company, the external, industry and economic scenario before interpreting results and drawing conclusions.

© 2017Wiley


Firms ertjoy significant latitude in the choice of accounting methods that are acceptable given the jurisdiction in which they operate. For example, under U.S. GAAP, companies can:

o Use the FIFO, AVCO, or LIFO inventory cost flow assumption. o Choose from a variety of depreciation methods.

Comparing ratios of firms across international borders is even more difficult in that most countries use IFRS. Despite the growing convergence between IFRS and U.S. GAAP, significant differences remain, which make it very difficult for analysts to compare ratios of firms that use different accounting standards.

It is also important to understand that the exact definitions of certain ratios vary across the analyst community. For example, in measuring leverage, some analysts use total liabilities, while others using only interest-bearing debt.

LESSON 2: COMMON RATIOS USED IN FINANCIAL ANALYSIS

LOS 27b: Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. Vol 3, pp 33S-359

Ratios are typically classified into the following categories:

Activity ratios measure how productive a company is in using its assets and how efficiently it performs its everyday operations.

Liquidity ratios measure the company's ability to meet its short-term cash requirements.

Solvency ratios measure a company's ability to meet long-term debt obligations.

Profitability ratios measure a company's ability to generate an adequate return on invested capital.

Valuation ratios measure the quantity of an asset or flow (e.g., earnings) associated with ownership of a specific claim (e.g., common stock).

These categories are not mutually exclusive. Some ratios are useful in evaluating multiple aspects of the business. Certain profitability ratios, for example, also reflect the operating efficiency of the business.

Interpretation and Context

The financial ratios of a company are compared to those of its major competitors in crosssectional analysis. A company's ratios for a given year can also be compared to its own prior period ratios to identify trends. The goal of ratio analysis is to understand the causes of material differences in ratios of a company compared to its peers. An analyst should evaluate financial ratios based on the following:

Actual ratios should be compared to the company's stated objectives. This helps in determining whether the company's operations are moving in line with its strategy.

©2017Wiley

Research has shown that in addition to being useful in evaluating the past perfonnance of a company, ratios can be useful in predicting future earnings and equity returns.


A company's ratios should be compared with those of others in the industry. When comparing ratios between firms from the same industry, analysts must be careful because:

o Not all ratios are important to every industry. o Companies may have several lines of business, which can cause aggregate

financial ratios to be distorted. In such a situation, analysts should evaluate ratios for each segment of the business in relation to relevant industry averages.

o Companies might be using different accounting standards. o Companies could be at different stages of growth or may have different strat

egies. This can result in different values for various ratios for firms in the same industry.

Ratios should be studied in light of the current phase of the business cycle.

Exhibit 2-1 contains the financial statements of ABC Company, which we will use to calculate and interpret various financial ratios.

Exhibit 2-1: Financial Statements for ABC Company

Income Statement

2006 2007

$ $ Total revenue 400,000 500,000

Cost of goods sold (COGS) (320,000) (380,000)

Gross profit 80,000 120,000

General expenses (28,000) (29,000)

Depreciation (8,000) (12,000)

Operating income 44,000 79,000

Interest income 3,000 2,000

Interest expense (400) (1,800)

Other losses (1800) (4,200)

Income before income 44,800 75,000 taxes Provision for income taxes (16,000) (21,000)

Net income 28,800 54,000

© 2017Wiley



Balance Sheet

2006 2007 $ $

Assets Current Assets Cash 21 ,000 32,000 Short-term investments 15,000 22,000 Accounts receivable 27,000 34,000 Inventories 16,000 34,000 Prepaid expenses 21 ,500 27,500 Total Current Assets 100,500 149,500

Fixed Assets Property and equipment 110,000 180,000 Long-term investments 13,000 4,000 Intangible assets 16,000 56,000 Other long-term assets 12,000 14,000 Total Fixed Assets 151,000 254,000

Total Assets 251,500 403,500

Liabilities Current Liabilities Accounts payable 27,000 20,000 Accrued expenses 12,700 17,000 Total Current Liabilities 39,700 37,000 Long-Term Debt 21,800 83,000

Shareholders' Equity Common stock 120,000 180,000 Accumulated other comprehensive income 0 -1,500 Retained earnings 70,000 100,000 General reserves 0 5,000 Total Shareholders' Equity 190,000 283,500

Total Liabilities and Shareholders' Equity 251,500 403,500

Activity Ratios

Activity ratios are also known as asset utilization ratios or operating efficiency ratios. They measure how well a company manages its operations and particularly how efficiently it manages its assets-working capital and long-lived assets. See Table 2-1.

©2017Wiley

Fl NANCIAL ANALYSIS TECHNIQUES

The ratios calculated herearefor2007.

Inventory turnover = Cost of goods sold Average inventory

Table 2-1: Definitions of Commonly Used Activity Ratios'

Activity Ratios Numerator

Inventory turnover Cost of goods sold

Days of inventory on Number of days in hand(DOH) period

Receivables turnover Revenue

Days of sales outstanding Number of days in (DSO) period

Payables turnover Purchases

Number of days of Number of days in payables period

Working capital turnover Revenue

Fixed asset turnover Revenue

Total asset turnover Revenue

Denominator

Average inventory

Inventory turnover

Average receivables

Receivables turnover

Average trade payables

Payables turnover

Average working capital

Average net fixed assets

Average total assets

This ratio is used to evaluate the effectiveness of a company's inventory management. Generally, this ratio is benchmarked against the industry average.

A high inventory turnover ratio relative to industry norms might indicate highly effective management. Alternatively, it could also indicate that the company does not hold adequate inventory levels, which can hurt sales incase shortages arise. A simple comparison of the company's sales growth to the industry's growth in sales can indicate whether sales are suffering because too little stock is available for sale at any given point in time. A low inventory turnover relative to the rest of the industry can be an indicator of slow moving or obsolete inventory. It suggests that the company has too many resources tied up in inventory.

Inventory turnover of ABC Company= 3SO,OOO 15.2

(16,000+ 34,000) /2

Days of inventory on hand (DOH) = 365

Inventory turnover

I - Exhibit I 0, Volume 3, CPA Program Curriculum 2017

©2017Wiley

This ratio is inversely related to inventory turnover.

The higher the inventory turnover ratio, the shorter the length of the period that inventory is held on average.

Days of Inventory on hand of ABC Company = 365

= 24.0 days 15.2

Revenue Receivables turnover= ------

Average receivables

A high receivables turnover ratio might indicate that the company's credit collection procedures are highly efficient. However, a high ratio can also result from overly stringent credit or collection policies, which can hurt sales if competitors offer more lenient credit terms to customers. A low ratio relative to industry averages will raise questions regarding the efficiency of a company's credit or collection procedures. As with the inventory turnover ratio, a simple comparison of the company's sales growth with industry sales growth can help determine whether the reason behind a high receivables turnover ratio is strict credit terms or efficient receivables management.


Analysts can also compare current estimates of the company 's bad debts and credit losses with its own past estimates and peer companies' estimates to assess whether low receivables turnover is the result of credit management issues.

Receivables turnover of ABC Company = 5

00,000 16.4 (27,000 +34,000)/ 2

Days of sales outstanding (DSO) = . 365

Receivables turnover

The receivables turnover ratio and days of sales outstanding are inversely related. The higher the receivables turnover ratio, the lower the DSO.

DSO of ABC Company = 365

= 22.3days 16.4

Payables turnover = Purchases Average trade payables

The amount for purchases over the year is usually not explicitly stated on the income statement; it is typically only disclosed in the footnotes to the financial statements. You might be expected to calculate purchases using the following formula:

Purchases = Ending inventory+ COGS - Opening inventory

©2017Wiley


Payables turnover measures how many times a year the company theoretically pays off all its creditors.

A high ratio can indicate that the company is not making full use of available credit facilities and repaying creditors too soon. However, a high ratio could also result from a company making payments early to avail early payment discounts. A low ratio could indicate that a company ntight be having trouble making payments on time. However, a low ratio can also result from a company successfully exploiting lenient supplier terms. If the company has sufficient cash and short-term investments, the low payables turnover ratio is probably not an indication of a liquidity crisis. It is probably a result of lenient supplier credit and collection policies.

Payables turnover of ABC Company= 34,000 + 380,000- l 6,000 16.9 (27,000+20,000)/ 2

Number of days of payables = 365

Payables turnover

The number of days of payables is inversely related to the payables turnover ratio. The higher the payables turnover, the lower the number of days of payables.

Number of days of payables of ABC Company = 365

= 21.6 days 16.9

Working capital turnover= Revenue Average working capital

Working capital turnover indicates how efficiently the company generates revenue from its working capital. Working capital equals current assets ntinus current liabilities

A higher working capital turnover ratio indicates higher operating efficiency.

For 2007, ABC's opening working capital equals $60,800 ($100,500 - $39,700), and ending working capital equals $112,500 ($149,500 - $37,000). Therefore, average working capital for 2007 equals $86,650.

Working capital turnover of ABC Company= $5

00,000 = 5.77 $86,650

Revenue Fixed asset turnover= ------

Average fixed assets

© 2017Wiley

This ratio measures how efficiently a company generates revenues from its investments in long-lived assets.

A higher ratio indicates more efficient use of fixed assets in generating revenue. A low ratio could be an indicator of operating inefficiency. However, a low fixed asset turnover can also be the result of a capital intensive business environment. Companies that have recently entered a new business that is not fully operational also report low fixed asset turnover ratios. The fixed asset turnover ratio will be lower for a firm whose assets are newer than for a firm whose assets are relatively older. The older-asset firm will have depreciated its assets for a longer period so the book value of its fixed assets will be lower.

Fixed asset turnover of ABC Company= 5

00,000 2.47 (151,000+254,000) /2

Revenue Total asset turnover = ------


Total asset turnover measures the company's overall ability to generate revenues with a given level of assets.

A high ratio indicates efficiency, while a low ratio can be an indicator of inefficiency or the level of capital intensity of the business. This ratio also identifies strategic decisions by management. For example, a business that uses highly capital-intensive techniques of production will have a lower total asset turnover compared to a business that uses labor-intensive production methods.

500,000 Total asset turnover of ABC Company= (2Sl,

500+

40J,

500)/

2 1.53

Liquidity Ratios

Analysis of a company's liquidity ratios aims to evaluate a company's ability to meet its short-term obligations. Liquidity measures how quickly a company can convert its assets into cash at prices that are close to their fair values. See Table 2-2.

Current ratio = Current assets Current liabilities

A higher ratio is desirable because it indicates a higher level of liquidity.


A current ratio of 1.0 indicates that the book value of the company' s current assets equals the book value of its current liabilities. A low ratio indicates less liquidity and implies a greater reliance on operating cash flow and outside financing to meet short-term obligations. The current ratio assumes that inventory and accounts receivable can readily be converted into cash at close to their fair values.

©2017Wiley


Current ratio of ABC Company= t 49,5oo = 4.04

37,000

Quick ratio= Cash+ Short-term marketable investments+ Receivables Cunent liabilities

Table 2-2: Definitions of Commonly Used Liquidity Ratios'

Liquidity Ratios Numerator Denominator

Current ratio Current assets Current liabilities

Quick ratio Cash+ Short-term marketable Current liabilities investments + Receivables

Cash ratio Cash+ Short-term marketable Current liabilities investments

Defensive interval ratio Cash+ Short-term marketable Daily cash investments + Receivables expenditures

Additional Liquidity Measure

Cash conversion cycle (net operating cycle)

DOH+ DSO - Nwnber of days of payables

The quick ratio recognizes that certain current assets (such as prepaid expenses) represent costs that have been paid in advance in the current year and cannot usually be converted into cash. This ratio also considers the fact that inventory cannot be immediately liquidated at its fair value. Therefore, these cunent assets are excluded from the nwnerator in the calculation of the quick ratio. When inventory is illiquid, this ratio is a better indicator of liquidity than current ratio.

A high quick ratio indicates greater liquidity.

Quick ratio of ABC Company= 32,000+ 22,000+ 34,000 2.38 37,000

Cash ratio= Cash+ Short-term marketable investments Current liabilities

The cash ratio is a very reliable measure of an entity 's liquidity position in the event of an unforeseen crisis. This is because it only includes cash and highly liquid short-term investments in the numerator.

Cash ratio of ABC Company= 54

,000 = 1.46 37,000

Defensive interval ratio= Cash+ Short-term marketable investments+ Receivables Daily cash expenditures

2-fuhibit 12, Volume 3, CFA Program Curriculum2017

© 2017Wiley

This ratio measures how long the company can continue to meet its daily expense requirements from its existing liquid assets without obtaining any additional financing. A defensive interval of 40 indicates that the company can pay its operating expenses for 40 days by liquidating its quick assets.

A high defensive interval ratio is desirable as it indicates greater liquidity. If a company's defensive interval ratio is very low compared to the industry average, the analyst might want to determine whether significant cash inflows are expected in the near future to meet expense requirements.

Cash conversion cycle = DSO +DOH - Number of days of payables

The cash conversion cycle (also known as net operating cycle) measures the length of the period between the point that a company invests in working capital and the point that the company collects cash proceeds from sales. Specifically, it is the time between the outlay of cash (to pay off accounts payable for credit purchases) and the collection of cash (from accounts receivable for goods sold on credit).

A shorter cycle is desirable, as it indicates greater liquidity.


A longer cash conversion cycle indicates lower liquidity. It implies that the company has to finance its inventory and accounts receivable for a longer period of time.

Cash conversion cycle of ABC Company= 24+ 22.3 - 21.6 = 24.7 days

Solvency Ratios

Solvency refers to a company's ability to meet its long-term debt obligations. Solvency ratios measure the relative amount of debt in a company's capital structure and the ability of earnings and cash flows to meet debt-servicing requirements. The amount of debt in the capital structure is important to assess a company 's degree of financial leverage (its financial risk). If the company can earn a return on borrowed funds that is greater than interest costs, the inclusion of debt in the capital structure will increase shareholder wealth. See Table 2-3.

Total debt Debt-to-assets ratio= ---

Total assets

©2017Wiley


When evaluating a company's solvency ratios,itisimJX>rtant to consider the volatility of the company's cash flows. Companies with stable cash flow streams are typically able to take on more debt.

ABC has no shortterm debt.

Table 2-3: Definitions of Commonly Used Solvency Ratios3

Solvency Ratios Numerator

Debt Ratios

Debt-to-assets ratio Total debt

Debt-to-capital ratio Total debt

Debt-to-equity ratio Total debt

Financial leverage ratio Average total assets

Coverage Ratios

Interest coverage EBIT

Fixed charge coverage EBIT + Lease payments

Denominator

Total assets

Total debt + Total shareholders ' equity


Average total equity

Interest payments

Interest payments + Lease payments

"Total debt ratio" is another name sometimes used for the debt-to-assets ratio. In this reading, we take total debt in this context to be the sum of interest-bearing short.term and long-term debt.

Important: In this reading, we take total debt in this context to be the sum of interestbearing short-term and long-term debt. The debt-to-asset ratio measures the proportion of the firm's total assets that have been financed by debt.

A higher DI A ratio is undesirable because it implies higher financial risk and a weaker solvency position.

Debt to assets ratio of ABC Company= 83

•000

= 0.21 403,500

Total debt Debt-to-capital ratio = -----------

Total debt+Shareholders' equity

This ratio measures the proportion of a company's total capital (debt plus equity) that is composed of debt.

A higher ratio indicates higher financial risk and is undesirable.

Debt to capital ratio of ABC Company= 33.ooo 0.23

83,000 + 283,500

Debt-to-equity ratio Total debt

Shareholders' equity

3 - Exhibit 14, Volume 3, CFA Program Curriculum 201 7

©2017Wiley

This ratio measures the amount of debt capital relative to a firm's equity capital.

A higher ratio is undesirable and indicates higher financial risk. A ratio of 1.0 indicates equal amounts of debt and equity in the company's capital structure.

Debt to equity ratio of ABC Company= 83

·000 = 0.29 283,500

Financial leverage ratio = Average total assets Average total equity


This ratio measures the amount of total assets supported by each money unit of equity. For example, a leverage ratio of 2 means that each dollar of equity supports $2 worth of assets. This ratio uses average values for total assets and total equity and plays an important role in Dupont decomposition, which we study later in this reading.

The higher the leverage ratio, the more leveraged (dependent on debt for finance) the company.

Financial leverage ratio of ABC Company= (403•500+ 251•500)/ 2=1.38 (483,500+ 190,000)/ 2

Interest coverage ratio= EBIT Interest payments

This ratio measures the number of times a company's operating earnings (earnings before interest and tax, or EBIT) cover its annual interest payment obligations. This very important ratio is widely used to gauge how comfortably a company can meet its debtservicing requirements from operating profits.

A higher ratio provides assurance that the company can service its debt from operating earnings.

Interest coverage ratio of ABC Company= 79

.000 = 44 times. 1,800

Fixed charge coverage ratio = EBIT +Lease payments Interest payments+ Lease payments

This ratio relates the fixed charges or obligations of the company to its earnings. It measures the number of times a company's operating earnings can cover its interest and lease payments.

A higher ratio suggests that the company is comfortably placed to service its debt and make lease payments from the earnings it generates from operations.

Fixed charge coverage ratio for ABC Company= 79

.000 = 44 times. 1,800

ABC has no lease payments.

©2017Wiley


Profitability Ratios The ability of a company to generate profits is a key driver of the company's overall value and the value of the securities it issues. Therefore, many analysts consider profitability to be the focus of their analysis.

Before moving on to any profitability ratios, you should be fantiliar with a few terms, such as gross profit, operating profit, net profit, and so on. These are linked in the income statement as follows:

Net sales

Cost of goods sold

Gross profit

Operating expenses

Operating profit (EBIT)

Interest

Earnings before tax (EBT)

Taxes

Earnings after tax (EAT)

+/- Below the line items adjusted for tax

Net income

Preferred dividends

Income available to common shareholders

Gross profit margin = Gross profit Revenue

The gross profit margin tells us the percentage of a company's revenues that are available to meet operating and nonoperating expenses. A high gross profit margin can be a combination of high product prices (reflected in high revenues) and low product costs (reflected in low COGS).

Gross profit margin of ABC Company = 12

0,000 = 24% 500,000

Operating profit margin = Operating profit Revenue

Operating profits are calculated as gross profit minus operating costs.

An operating profit margin that is increasing at a higher rate than the gross profit margin indicates that the company has successfully controlled operating costs. A decreasing operating profit margin when gross profit margins are rising indicates that the company is not efficiently controlling operating expenses.

Operating profit margin of ABC Company = 79

.000 = 15.8% 500,000

p . EBT( earnings before tax, but after interest) retax margtn = -~~-~--R-e-ve_n_u_e-----~

© 2017Wiley

Pretax income is also called earnings before tax (EBT). It is calculated as operating income minus nonoperating expenses plus nonoperating income.


If a company's pretax margin is rising primarily due to higher nonoperating income, the analyst should evaluate whether this source of income will continue to bring in significant earnings going forward.

Pretax margin of ABC Company= 75

,000 = 15% 500,000

Net profit margin = Net profit Revenue

Net profit margin shows how much profit a company makes for every dollar it generates in revenue.

A low net profit margin indicates a low margin of safety. It alerts analysts to the risk that a decline in the company's sales revenue will lower profits or even result in a net loss (reduction in shareholder wealth).

Net profit margin of ABC Company = 54

,000 = 10.8% 500,000

ROA = __ N_e_t _in_c_o_m_e __ Average total assets

Return on assets measures the return earned by the company on its assets.

The higher the ROA, the greater the income generated by the company given its total assets.

ROA of ABC Com an = 54

,000 16.5% p y (251,500+403,500)/2

The problem with this calculation of ROA (net income/average total assets) is that it uses only the return to equity holders (net income) in the numerator. Assets are financed by both equity holders and bond holders. Therefore, some analysts prefer to add interest expense back to net income in the numerator. However, interest expense must be adjusted for the tax shield that it provides. The adjusted ROA is computed as:

Adjusted ROA= Net income+ Interest expense(l -Tax rate) Average total assets

©2017Wiley


ABC pays no preferred dividends.

Some analysts choose to calculate ROA on a pre-interest and pre-tax basis as:

Operating ROA = Operating income or EBIT Average total assets

This ratio reflects the return on all assets used by the company, whether financed with debt or equity.

. 79,000 Operating ROA of ABC Company= (

251,500

+403

,500

)/2

24.1%

Note: Whichever formula is used to calculate ROA, the analyst must use it consistently in cross-sectional analysis and trend analysis.

Return on total capital = EBIT Short-term debt+ Long-term debt+ Equity

This ratio measures the profits that a company earns on all sources of capital that it employs- short-term debt, long-term debt, and equity. Once again, returns are measured prior to deducting interest expense.

Return on total capital of ABC Company= 79

,000 21.6% (83,000+ 283,500)

Return on equity = __ N_e_t _in_c_o_m_e __ Average total equity

ABC pays no preferred dividends.

This ratio measures the rate of return earned by a company on its equity capital. Equity capital includes minority equity, preferred equity, and common equity. It measures a firm's efficiency in generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses its investment dollars to generate earnings. ROE is commonly used to compare the profitability of a company to that of other firms in its industry.

ROE of ABC Company= 54

,000 = 22.8% (190,000+283,500)12

R . Net income - Preferred dividends

eturn on common eqwty = . Average common eqwty

This ratio measures the return earned by a company only on its common equity.

Return on common equity of ABC Company= 54

,000 36% (120,000+ 180,000)/ 2

See Table 2-4.

© 2017Wiley

Table 2-4 Definitions of Commonly Used Profitability Ratios4

Profitability Ratios

Return on Sales

Gross profit margin

Operating profit margin

Pre-tax margin

Net profit margin

Return on Investment

Operating ROA

ROA

Return on total capital

ROE

Return on common equity

Numerator

Gross profit

Operating income

EBT (earnings before tax but after interest)

Net income

Operating income

Net income

EBIT

Net income

Net income - Preferred dividends

4 -Exhibit IS, Volume 3, CPA Program Curriculum 2017

©2017Wiley

Denominator

Revenue

Revenue

Revenue

Revenue




Short- and long-term debt and equity

Average total equity

Average common equity


LOS 27c: Describe the relationships among ratios and evaluate a company using ratio analysis. Vol 3, pp 359-361

Example 2-1: Evaluating a Company Using a Combination of Ratios

An analyst obtains the following liquidity ratios of a Taiwanese manufacturing company:

2008 2007 2006

Current ratio

Quick ratio

2.2

0.7

2.0

0.8

1.7

0.9

The increase in the current ratio over the years, from 1.7 to 2.2, suggests that the company's liquidity position has strengthened. However, the decline in the quick ratio over the years, from 0.9 to 0.7, suggests that the liquidity position of the company has deteriorated. Both ratios have current liabilities as the denominator. Therefore, the difference must be due to the changes in certain current assets that are not included in the quick ratio (e.g., inventories).

To evaluate the disconnect between the suggestions offered by the trend in current and quick ratios regarding the company 's liquidity position, the analyst obtains the following DOH and DSO figures for the company:

DOH

DSO

2008

56

25

2007

46

29

2006

31

51

The company's DOH has increased from 31 days to 56, which implies that the company is holding higher levels of inventory. The decrease in DSO indicates that the company is collecting on its receivables more quickly than before. Taking all these ratios together, we can reach the conclusion that although the company is collecting on its receivables more quickly than before, the proceeds from sales are being used to purchase inventory which is not being sold as quickly. Therefore, the company's quick ratio is suffering, but not its current ratio.

©2017Wiley

Example 2-2: Comparing Two Companies Using Ratios

An analyst is given the following information about two companies that operate in the same industry:

Company A 2008 2007 2006 2005

Inventory turnover 75.59 87.08 149.29 188.74 DOH 5.67 5.01 3.74 2.59 Receivables turnover 11.57 9.66 12.41 8.45 DSO 34.67 40.31 33.23 49.89 Accounts payable turnover 5.52 5.26 5.74 5.12 Days payable 79.87 84.88 76.29 87.78 Cash from operationsfrotal liabilities 41.31 % 21.34% 9.89% 18.67%

ROE 7.56% 2.91% 2.82% -0.54% ROA 4.70% 2.05% 2.05% -0.34% Net profit margin 3.95% 2.47% 2.49% -0.56% Total asset turnover 1.19 0.83 0.82 0.60 Leverage (Average assets/Average equity) 1.61 1.42 1.38 1.61

CompanyB 2008 2007 2006 2005

Inventory turnover 11.29 11.07 9.23 16.18 DOH 40.12 41.23 49.11 26.45 Receivables turnover 7.98 6.76 5.34 4.21 DSO 44.32 53.26 60.98 70.59 Accounts payable turnover 6.78 6.98 7.45 6.81 Days payable 55.76 54.23 48.13 54.98 Cash from operationsfTotal liabilities 14.31% 17.34% 16.89% 12.67%

ROE 9.53% 6.85% -4.07% -6.60% ROA 4.72% 3.55% -1.95% 3.13% Net profit margin 4.63% 3.45% -1.43% -2.63% Total asset turnover 1.02 1.03 1.36 1.19 Leverage (Average assets/Average equity) 2.02 1.93 2.09 2.11

Which of the following choices best describes a reasonable conclusion that an analyst might make about the companies' efficiency levels?

A. Over the 4-year period, Company A has shown greater improvement in efficiency than Company B, as indicated by its total asset turnover ratio increasing from 0.60 to 1.19.

B. In 2007, Company A's DOH of only 5.01 indicates that it was less efficient at inventory management than Company B, which had a DOH of 41.23.

©2017Wiley



C. In 2008, Company B's receivables turnover of 7.98 indicates that it was more efficient at receivables management than Company A, which had a receivables turnover of 11.57.

D. Over the 4 years, Company B has shown greater improvement in efficiency than Company A, as indicated by its net profit margin of 4.62%.

Comments

Choice A is correct because over the given period, Company A has shown greater improvement in efficiency than Company B. Company A's total asset turnover (a measure of operating efficiency) has almost doubled from 0.60 to 1.19. Over the same period, Company B total asset turnover has declined from 1.19 to 1.05. Choice B is incorrect because it misinterprets DOH. All other factors constant, a lower DOH indicates better inventory management. Choice C is incorrect because it misinterprets receivables turnover. All other factors constant, a higher receivables turnover indicates greater efficiency in receivables management. Choice D is incorrect because net profit margin is not an indicator of efficiency. It is an indicator of profitability.

LESSON 3: DUPONT ANALYSIS, EQUITY ANALYSIS, CREDIT ANALYSIS, AND BUSINESS AND GEOGRAPHIC SEGMENTS

LOS 27d: Demonstrate the application of DuPont analysis of return on equity and calculate and interpret effects of changes in its components. Vol 3, pp 362-366

ROE measures the return a company generates on its equity capital. Decomposing ROE into its components through DuPont analysis has the following uses:

It facilitates a meaningful evaluation of the different aspects of the company's performance that affect reported ROE. It helps in determining the reasons for changes in ROE over time for a given company. It also helps us understand the reasons for differences in ROE for different companies over a given time period. It can direct management to areas that it should focus on to improve ROE. It shows the relationship between the various categories of ratios and how they all influence the return that owners realize on their investment.

Decomposition of ROE

ROE = __ N_e_t _in_c_o_m_e __ Average total equity

© 2017Wiley


Tuo-Way DuPont Decomposition

This decomposition breaks ROE down into two components.

ROE_ Net income x Average total assets

Average total assets Average shareholder's equity

ROA Leverage

The two-way breakdown of ROE illustrates that ROE is a function of company's return on assets (ROA) and financial leverage ratio. A company can improve its ROE by improving ROA or by using leverage (debt) more extensively to finance its operations. As long as a company is able to borrow at a rate lower than the marginal rate it can earn by investing the borrowed money in its business, taking on more debt will result in an increase in ROE. However, if a company's borrowing costs exceed its marginal return, taking on more debt would depress ROA and ROE as well. Table 3-1 decomposes the ROE for Company A in Example 2 into two components:

Table 3-1: Company A 2-Way DuPont Decomposition

ROE ROA x Leverage

2008 7.56% 4.70% 1.61

2007 2.91% 2.05% 1.42

2006 2.82% 2.05% 1.38

2005 -0.54% -0.34% 1.61

Analysis: Over the period, the company's financial leverage ratio was relatively stable. The increase in the company's ROE was primarily due to an increase in profitability (ROA).

Three-Way DuPont Decomposition

This decomposition expresses ROE as a product of three components.

ROE Net income x Revenue x Average total assets

Revenue Average total assets Average shareholders' equity

Net profit margin Asset turnover Leverage

This decomposition illustrates that a company's ROE is a function of its net profit margin, asset turnover ratio, and financial leverage ratio.

Net profit margin is an indicator of profitability. It shows how much profit a company generates from each money unit of sales. Asset turnover is an indicator of efficiency. It tells us how much revenue a company generates from each money unit of assets. ROA is a function of its profitability (net profit [NP] margin) and efficiency (asset turnover [TO]). Financial leverage is an indicator of solvency. It reflects the total amount of a company's assets relative to its equity capital.

©2017Wiley


Some candidates get confused as to how a higher tax or interest "burden" ratio can improve the ROE. The key is not to focus on the English. The ratios are just called burden ratios, but a higher ratio does not mean that there is literally more ofataxorintcrest "burden" on the company. In fact, itistheopIXJsite. A higher tax and interest burden ratio is actually better for the company. Focus on the math behind the ratio, not the English behind its

Table 3-2 breaks down the ROE for Company A from Example 2-1 into three components:

Table 3-2: Company A Three-Way DuPont Decomposition

ROE NP margin x Asset TO x Leverage

2008 7.56% 3.95% 1.19 1.61

2007 2.91% 2.47% 0.83 1.42

2006 2.82% 2.49% 0.82 1.38

2005 -0.54% -0.56% 0.60 1.61

The increase in Company i'<s ROE is a result of better NP margins (improved profitability) and higher asset turnover (improved efficiency), which improved its ROA and its ROE.

Five-Way DuPont Decomposition

To separate the effects of taxes and interest, we can further decompose ROE into five components.

Interest burden Asset turnover

i ROE= Net income x EBT x EBIT x Revenue x Average total assets

EBT EBIT Revenue Average total assets Avg. shareholders' equity

Tax burden EB!Tmargin Leverage

This decomposition shows that ROE is a function of the company's tax burden, interest burden, operating profitability, efficiency, and leverage. See Exhibit 3-1.

The tax burden ratio equals one minus the average tax rate. It basically measures the proportion of its pretax profits that a company gets to keep. A higher tax burden ratio implies that the company can keep a higher percentage of its pretax profits. A decrease in the tax burden ratio implies the opposite. The interest burden ratio captures the effect of interest expense on ROE. High borrowing costs reduce ROE. As interest expense rises, EBT will fall as a percentage of EBIT, the interest burden ratio will fall , and ROE will also fall. The EBIT margin captures the effect of operating profitability on ROE. We already know that the asset turnover ratio is an indicator of the overall efficiency of the company, while the leverage ratio measures the total value of a company's assets relative to its equity capital.

© 2017Wiley

Exhibit 3-1: Company A Five-Way DuPont Decomposition for 2008

Return on Average Shareholders' Equity or ROE

Return on Assets Leverage

7.56%


The calculated value for ROE will be the same under every kind of decomposition. DuPont analysis is a way of decomposing ROE to see more clearly the underlying changes in the company's operations that drive changes in its ROE.

In general, higher profit margins, asset turnover, and leverage will lead to higher ROE. However, the five-way decomposition shows that an increase in leverage will not always increase ROE. This is because as the company takes on more debt, its interest costs rise and the interest burden ratio falls. The reduction in interest burden ratio (as the difference between EBT and EBIT increases) offsets the effect of the increase in the financial leverage ratio.

Example 3-1: Five-Way Decomposition of ROE


2011 2010 2009 2008 2007

ROE 9.47% 15.00% 24.31% 25.82% 24.07%

Tax burden 64.85% 59.37% 63.24% 58.20% 62.58%

Interest burden 92.58% 92.45% 92.74% 92.85% 92.61%

EBITmargin 8.63% 10.41% 13.24% 15.69% 14.35%

Asset turnover 0.85 1.21 1.47 1.44 1.58

Leverage 2.15 2.17 2.13 2.19 2.18

©2017Wiley


Based on this information, comment on the negative trend in the company's ROE.

Solution:

The following conclusions may be drawn from the given information:

The tax burden ratio has varied with no obvious trend over the years. The recent increase in tax burden ratio (from 59.37% in 2010 to 64.85% in 2011) indicates that taxes declined as a percentage of pre-tax profits. Average tax rates may have declined as a result of (1) new legislation or (2) greater revenue generated in lower tax jurisdictions. The interest burden ratio remained fairly constant over the period, which suggests that the company's capital structure has remained fairly constant. The EBIT margin declined over the period, indicating that the company's operations were less profitable. The company's asset turnover declined over the period, which suggests that the company is becoming increasingly inefficient. The financial leverage ratio remained fairly constant over the period, which is consistent with the stable interest burden ratio.

Overall, the decline in the company's ROE is mainly caused by a decline in the EBIT margin (profitability) and asset turnover (efficiency).

LOS 27e: Calculate and interpret ratios used in equity analysis and credit analysis. Vol 3, pp 366-378

Equity Analysis

Analysts use a variety of methods to value a company's equity. One of the most common method involves the use of valuation ratios.

Valuation Ratios

Price-to-Earnings Ratio

PIE= Price per share Earnings per share

The PIE ratio expresses the relationship between the price per share of common stock and the amount of earnings attributable to a single share. It basically tells us how much a share of common stock is currently worth per dollar of earnings of the company.

Other commonly used valuation ratios include:

Price to Cash Flow

P/CF = Price per share Cash flow per share

©2017Wiley

Price to Sales

PIS = Price per share Sales per share

Price to Book Value

P/BV = Price per share Book value per share

Per Share Quantities that are Important in Equity Analysis

Net income- Preferred dividends BasicEPS = -------------------

Weighted average number of ordinary shares outstanding


Basic EPS are the earnings of a company attributable to each share of common stock. The weighted average number of shares consists of the number of ordinary shares outstanding at the beginning of the period, adjusted for those bought back or issued during the period, weighted by the length of time that they were outstanding during the relevant period.

Adjusted income available for ordinary shares

Diluted EPS = __ re_ fl_ec_un_· ~g_c_o_n_v_ers_io_n_o_f_d_i_lu_ti_v_e_s_ec_un_·u_·e_s __

Weighted average number of ordinary and potential ordinary shares outstanding

Diluted EPS includes the effects of all outstanding securities whose conversion or exercise will result in a reduction in EPS. Dilutive securities include convertible debt, convertible preference shares, warrants, and options.

Cash flow per share = Cash flow from operations Average number of shares outstanding

EBITDA per share = EBITDA Average number of shares outstanding

Dividends per share = Common dividends declared Weighted average number of ordinary shares

©2017Wiley


Dividend Related Quantities

Dividend payout ratio = Common share dividends Net income attributable to common shares

The dividend payout ratio measures the percentage of earnings that a company pays out as dividends to shareholders. The per-share dividend paid by companies is typically fixed, so this ratio fluctuates as a percentage of earnings. Therefore, conclusions about a company's dividend payout policy should be based on examination of the payout ratio over a number of periods.

Retention rate = _N_e_t _in_c_o_m_e_a_ttn_ ._b_u_ta_b_le_t_o_c_o_mm __ on_ sh_are_ s_-_ C_o_mm_ o_n_ sh_are __ d_iv_id_e_n_d_s

Net income attributable to common shares

This ratio measures the percentage of earnings that a company retains and reinvests in the business.

Retention rate = (I - Dividend payout ratio)

I Sustainable growth rate =Retention rate x ROE I

A company's sustainable growth rate is a function of its profitability (ROE) and its ability to finance its operations from internally generated funds (measured by the retention rate). Higher ROE and higher retention rates result in a higher sustainable growth rates.

Example 3-2: Calculating the Sustainable Growth Rate

The following data is available for Sedag Inc. Calculate its sustainable growth rate

EPS

Dividends per share

Return on equity

Solution

$3

$1

10%

Dividend payout ratio= $11$3 = 0.33 Retention Ratio = I - 0.33 = 0.67 Sustainable growth rate (g) = 0.67 x 10% = 6. 7%

See Table 3-3 for definitions of selected valuation ratios and related quantities.

© 2017Wiley


Table 3-3: Definitions of Selected Valuation Ratios and Related Quantities5

Numerator Denominator

Valuation ratios

PIE Price per share Earnings per share P/CF Price per share Cash flow per share P/S Price per share Sales per share P/BV Price per share Book value per share

Pre-share quantities

Basic EPS Net income minus Weighted average number preferred dividends of ordinary shares

outstanding

Diluted EPS Adjusted income available Weighted average number for ordinary shares, of ordinary and potential reflecting conversion of ordinary shares outstanding dilutive securities

Cash flow per share Cash flow form operations Average number of shares outstanding

EBITDA per share EBITDA Average number of shares outstanding

Dividends per share Common dividends Weighted average number declared of ordinary shares

outstanding

Dividend-related quantities

Dividend payout ratio Common share dividends Net income attributable to common shares

Retention rate (b) Net income attributable to Net income attributable to common shares - common common shares share dividends

Sustainable growth rate bx ROE

Industry-Specific Ratios

Aspects of performance that are deemed relevant in one industry may be irrelevant in another. Industry-specific ratios reflect these differences.

For companies in the retail industry, changes in same store sales should be tracked. This is because it is important to distinguish between sales growth generated from opening new stores and sales growth resulting from higher sales at existing stores. Regulated industries are required to adhere to specific regulatory ratios. The banking sector has liquidity and cash reserve ratio requirements. Banking capital adequacy requirements relate banks ' solvency to their specific levels of risk exposure.

Table 3-4 lists some industry-specific ratios.


©2017Wiley

Studies have shown that, in addition to being useful in evaluating the past perfonnance of a company, ratios and comon-sizemetrics from accounting data are useful in forecasting earnings and sLOCk returns.


Table 3-4: Definitions of Some Common Industry and Task-Specific Ratios6

Ratios

Business Risk

Coefficient of variation of operating income

Coefficient of variation of net income

Coefficient of variation of revenues

Financial Sector Ratios

Capital adequacy- Banks

Monetary reserve requirement

Liquid asset requirement

Net interest margin

Retail Ratios

Sarne store sales

Sales per square foot (meter)

Service Companies

Revenue per employee

Net income per employee

Hotels

Average daily rate

Occupancy rate

Numerator

Standard deviation of operating income

Standard deviation of net income

Standard deviation of revenues

Various components of capital

Reserves held at central bank

Approved "readily marketable securities"

Net interest income

Average revenue growth year on year for stores open in both periods

Revenue

Revenue

Net income

Room revenue

Number of rooms sold

6 - fuhibit 19, Volume 3, CFA Program Curriculum201 7

Denominator

Average operating income

Average net income

Average revenue

Risk weighted assets, market risk exposure, and level of operational risk assumed

Specified deposit liabilities

Specified deposit liabilities

Total interest-earning assets

Not applicable

Total retail space in feet or meters

Total number of employees

Total number of employees

Number of rooms sold

Number of rooms available

© 2017Wiley

Credit Analysis

Credit risk is the risk of loss that is caused by a debtor's failure to make a promised payment. Credit analysis is the evaluation of credit risk.

The Credit-Rating Process


The credit-rating process involves the analysis of a company's financial reports and a broad assessment of a company's operations. It includes the following procedures:7

Meetings with management. Tours of major facilities, if time permits. Meetings of ratings committees where the analyst 's recommendations are voted on, after considering factors that include:

o Business Risk, including the evaluation of: Operating environment. Industry characteristics. Success areas and areas of vulnerability. Company's competitive position, including size and diversification.

o Financial risk, including: The evaluation of capital structure, interest coverage, and profitability using ratio analysis. The examination of debt covenants.

o Evaluation of management Monitoring of publicly distributed ratings, including reconsideration of ratings due to changing conditions.

In assigning credit ratings, rating agencies emphasize the importance of the relationship between a company's business risk profile and its financial risk.

7 -Based on Standard & Poor's Corporate Ratings Criteria (2006).

©2017Wiley


Studies have shown that ratios like the ROA, long-tenn DIA, interest coverage, and cash now to debt are very useful in evaluating credit risk, bond yields, and bond ratings.

LOS 27f: Explain the requirements for segment reporting and calculate and interpret segment ratios. Vol 3, pp 376-379

Table 3-5: Selected Credit Ratios Used by Standard & Poor's8

Credit Ratio

EBIT interest coverage

EBITDA interest coverage

Funds from operations to total debt

Free operating cash flow to total debt

Return on capital

Total debt to total debt plus equity

Numerator"

EBIT

EBITDA

Denominatorh

Gross Interest (prior to deductions for capitalized interest or interest income)

Gross Interest (prior to deductions for capitalized interest or interest income)

FFO (net income Total debt adjusted for noncash items)'

CFO (adjusted) less Total debt capital expendituresd

EBIT Capital =Average equity (common and preferred equity) and short-term portions of debt, noncurrent deferred taxes, minority interest

Total debt Total debt plus equity

aNumerator: Emphasis is on earnings from continuing operations. bDenominator: Both numerator and denominator definitions are adjusted from ratio to ratio and may not correspond to the definitions used in this reading. cFFO: Funds from operations. dCFO: Cash flow from operations.

Source: Based on data from Standard and Poor's Corporate Ratings Criteria 2006.

Segment Analysis

Analysts often need to analyze the performance of underlying business segments to understand the company as a whole. These segments may include subsidiary companies, operating units, or simply operations in different geographical areas.

A business segment is a separately identifiable component of a company that is engaged in providing an individual product or service or a group of related products or services. It is subject to risks and returns that are different from those of other business segments of the company.

A geographical segment is a distinguishable component of a company that is engaged in providing an individual product or service within a particular region.


©2017Wiley


Table 3-6: Segment Ratios•

Segment Ratios Numerator Denominator Measures

Segment margin Segment profit (loss) Segment revenue Operating profitability relative to sales.

Segment turnover Segment revenue Segment assets Overall efficiency- how much revenue is generated per dollar of assets.

Segment ROA Segment profit (loss) Segment assets

Segment debt ratio Segment liabilities Segment assets

Example 3-3: Evaluation of Segment Ratios

Operating profitability relative to assets.

Solvency of the segment.

Tiara Corp. divides its operations in three geographical segments. Selected financial information is provided in the following table:

2011 2010 (in$'000) Operating Operating

Revenue Income Assets Revenue Income Assets

Australia 272,310 39,485 231,464 210,258 29,436 189,232

Asia Pacific 668,484 60,164 534,787 581,290 61,035 494,097

Europe 144,085 25,215 100,860 115,268 18,443 86,451

Total 1,084,879 124,863 867,110 906,816 108,914 769,780

Comment on the relative performance of the three segments.

Solution:

To compare the relative significance and performance of the three segments, we compute segment margin, segment ROA, and segment turnover in the table below:

2011 2010

(in$'000) Segment Segment Revenue Revenue

as Percent Segment Segment Segment as Percent Segment Segment Segment of Total Margin ROA Turnover of Total Margin ROA Turnover

Australia 25.10% 14.50% 17.06% 1.2 23.19% 14.00% 15.56% I.I

Asia-Pacific 61.62% 9.00% 11.25% 1.3 64.10% 10.50% 12.35% 1.2

Europe 13.28% 17.50% 25.00% 1.4 12.71% 16.00% 21.33% 1.3

9 - Exhibit 21, Volume 3, CPA Program Curriculum 201 7

©2017Wiley


The following conclusions can be drawn from the table:

Asia-Pacific is the company's largest segment, as highlighted by its share of total revenue (61.62%). However, the segment has the lowest profit margin (9%). Further, the relative size of the segment has decreased over the year (share of revenues down from 64.10% to 61.62%). Europe has the highest profit margin (17.5%) and is the most efficient segment as well (it has the highest ROA and asset turnover). Australia's profit margin is also relatively high. Europe and Australia have improved in terms of both profitability and efficiency. It bodes well for the company that the relative size of these two segments is increasing (in terms of the share of total revenue).

LOS 27g: Describe how ratio analysis and other techniques can be used to model and forecast earnings. Vol 3, pp 379-380

In forecasting future earnings of companies, analysts use data about the economy, industry, and company itself. The results of financial analysis, which includes common-size and ratio analysis, are integral to this process.

Analysts also develop models and pro forma financial statements to forecast future performance. They are constructed using past trends and relationships and also account for expected future events and changes. Pro forma income statements are usual! y prepared by using the historical relationship between a company's income statement items and sales to project the nature of the relationship going forward. Items that are not sales-driven can be assumed fixed, or assumed to vary with a balance sheet item (e.g., interest expense varies with the amount of long-term liabilities). Some balance sheet items also vary with sales, especially working capital accounts. As the company's scale of operations increases, the firm has to increase its investment in working capital to ensure the smooth running of dayto-day operations. Further, investments in long-lived assets will also be required to expand the scale of the business.

Some other techniques that are used in making forecasts are:

Sensitivity Analysis, which shows the range of possible outcomes as underlying assumptions are altered.

Scenario Analysis, which shows the changes in key financial quantities that result from given events such as a loss of supply of raw materials or a reduction in demand for the firm 's products.

Simulations are computer-generated sensitivity or scenario analyses based on probability models for the factors that drive outcomes.

© 2017Wiley


ANALYSIS: INvENTORIES, LONG-LIVED ASSETS,

INCOME TAXES, AND NON-CURRENT LIABILITIES

©2017Wiley

READING 28: INvENTORIES

LESSON 1: COST OF INVENTORIES AND INVENTORY VALUATION METHODS

LOS 28a: Distinguish between costs included in inventories and costs recognized as expenses in the period in which they are incurred. Vol 3, pp 397-398

Cost of Inventories

IFRS and U.S. GAAP suggest a similar treatment of various expenses in the determination of inventory cost. The following items are capitalized inventory costs, which are included in the cost or carrying value of inventories on the balance sheet.

Costs of purchase, which include the purchase price, import duties, taxes, insurance, and other costs that are directly attributable to the acquisition of finished goods, trade discounts, and other rebates that reduce costs of purchase. Costs of conversion, which include direct labor and other (fixed and variable) direct overheads.

Capitalization of these costs results in a buildup of asset balances and delays recognition of these costs (in COGS) until inventory is sold.

The following items are not capitalized as inventory costs; they are expensed on the income statement as incurred under IFRS and U.S. GAAP.

Abnormal costs from material wastage. Abnormal costs of labor or wastage of other production inputs. Storage costs that are not a part of the normal production process. Administrative expenses. Selling and marketing costs.

Capitalization of costs that should be expensed results in overstatement of net income for the year (due to the deferral of recognition of costs) and an overstatement of inventory value on the balance sheet. See Example 1-1.

Example 1-1: Determination oflnventory Costs

ABC Company manufactures a single product. Various costs incurred during the year 2009 are listed here:

Cost of raw materials Direct labor conversion costs Production overheads Freight charges for raw materials Storage costs for finished goods Abnormal wastage Freight charges for finished goods

$12,000,000 $25,000,000

$5,000,000 $2,000,000

$800,000 $80,000

$100,000

Given that there is no work· in-progress inventory at the end of the year:

1. What costs should be included in inventory for 2009? 2. What costs should be expensed during 2009?

©2017Wiley

INVENTORIES

INVENTORIES

Please note that LOS 28d is also covered in the last lesson of this reading.

"CostofsaJes" (IFRS) is also referredtoas"cost of goods sold" (U.S. GAAP).

"Cost formulas" (IFRS)arealso referredtoas"cost now assumptions" (U.S.GAAP).

Solution

1. Capitalized inventory costs include raw material costs, labor conversion costs, production overheads, and freight charges on raw materials.

Cost of raw materials Direct labor conversion costs Production overheads Freight-in charges Total capitalized costs

$12,000,000 $25,000,000

$5,000,000 $2,000,000

$44,000,000

2. Costs that should be expensed on the income statement (and not included in the value of inventory on the balance sheet) include storage costs of finished goods, abnormal wastage, and freight on finished goods.

Storage costs of finished goods Abnormal wastage Freight on finished goods Total expensed costs

$800,000 $80,000

$100,000 $980,000

LOS 28b: Describe different inventory valuation methods (cost formulas). Vol 3, pp 398--400

LOS 28c: Calculate cost of sales and ending inventory using different inventory valuation methods and explain the effect of the inventory valuation method choice on gross profit. Vol 3, pp 400-402

LOS 28d: Calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies that use different inventory valuation methods. Vol 3, pp 404-406

Inventory Valuation Methods

Let's work with an example of a trading company that purchases and retails coffee tables. At any point in time, the number of tables that the company has available for sale equals the total number of tables that it had in its inventory at the beginning of the period plus the number of tables it has purchased since then. In order to prepare its financial statements for the period, the company must allocate the cost of all units available for sale between ending inventory (El) and cost of goods sold (COGS).

Opening inventory+ Purchases = Cost of goods sold+ Ending inventory ... (Equation I)

Inventory Valuation Methods (Cost Formulas)

Separate Identification COGS reflects actual costs incurred to purchase or manufacture the specific units that have been sold over the period.

©2017Wiley

EI reflects actual costs incurred to purchase or manufacture the specific units that still remain in inventory at the end of the period. This method is used for items that are not interchangeable and for goods produced for specific projects. It is used for expensive goods that can be identified individually (e.g. , precious gemstones). This method matches the physical flow of a particular inventory item with its actual cost.

First In, First Out (FIFO) Oldest units purchased or manufactured are assumed to be the first ones sold. Newest units purchased or manufactured are assumed to remain in ending inventory. COGS is composed of units valued at oldest prices. EI is composed of units valued at most recent prices.

Weighted Average Cost (AVCO)

This method allocates the total cost of goods available for sale (beginning inventory, purchases, and other inventory-related costs) evenly across all units available for sale.

COGS is composed of units valued at average prices. EI is also composed of units valued at average prices.

Last In, First Out (LIFO) Newest units purchased or manufactured are assumed to be the first ones sold. Oldest units purchased or manufactured are assumed to remain in ending inventory. COGS is composed of units valued at most recent prices. EI is composed of units valued at oldest prices.

IFRS allows companies to use any of three valuation methods for inventory-separate identification, FIFO, and AVCO. U.S. GAAP allows companies to use the three methods allowed under IFRS, and also accepts the LIFO method.

The freedom to choose a particular inventory valuation method affords companies significant flexibility in how they apportion costs between EI (current assets on the balance sheet) and COGS (expenses on the income statement). Given the value of beginning inventory and purchases for the year, it is obvious (from Equation I) that the higher the value of COGS, the lower the value allocated to EI and vice versa. Therefore, inventory valuation methods have a direct, material impact on financial statements and their comparability across companies.

If inventory purchase costs and manufacturing conversion costs were stable over time, it would be easy to apportion costs between EI and COGS. The number of units in inventory at the end of the year would be multiplied by the cost price per unit to compute EI, and the number of units sold multiplied by the cost price per unit to detennine COGS. However, if prices fluctuate over the period (which is usually the case), the allocation of inventory costs becomes complicated because the valuation method used has significant implications on the value of EI and COGS for the period. In Example 1-2, we illustrate how the LIFO, FIFO, and AVCO cost flow assumptions work, and demonstrate how they result in different values for EI and COGS when prices are not assumed constant over the period.

©2017Wiley

INVENTORIES

Under separate identification, costs remain in inventory until the specific unit is sold.

Under FlFO, UFO, and AVCO companies make an assumption about which goods are sold and which ones remain in inventory. Therefore, the allocation of costs to units sold and those in inventory can be different from the physical movement of inventory units.

A company must use the same inventory valuation methoclforallitems of a similar nature and use.

For items with a different nature or use, a different valuation method may be used.

INVENTORIES

Under FIFO, in periods of rising prices the prices assigned to units in ending inventory are higher than the prices assigned to units sold.

Example 1-2: Illustration of Methods of Inventory Valuation

At the beginning of the year, Nakamura Inc. had 5 units of inventory, which cost $8 each. Over the year the company purchased 52 units and sold 50 units, leaving it with 7 unsold units at the end of the year. Nakamura purchased 10 (cost; $10/unit), 12 (cost; $11/unit), 14 (cost; $12/unit), and 16 (cost; $13/unit) units and sold 13, 13, 12, and 12 units in the four quarters, respectively. All units were sold at $20 each. Determine the amounts that are allocated to EI and COGS for the year under the FIFO, LIFO, and AVCO cost flow assumptions.

Solution

First we must determine the total cost of goods available for sale that must be allocated between EI and COGS. This is done by summing the values of opening inventory (OI) and quarterly purchases:

Units Held/ Unit Cost Quarter Purchased $

Opening inventory 5

I 10 10

2 12 II

14 12

4 16 13

Total 57

FIFO

Under this method:

Older units are assumed to be the first ones sold. Units that are purchased recently are included in EL COGS is composed of units valued at older prices. EI is composed of units valued at recent prices.

COGS $ EI

Total Cost $

40

100

132

168

208

648

$

5 units at $8 from or 40 7 units at $13 left over from Q4 purchases 91

10 units at $10 from QI purchases 100

12 units at $11 from Q2 purchases 132



50 units 557 7 units 91

© 2017Wiley

LIFO

Under this method:

Recently acquired units are assumed to be the first ones sold. Oldest units are included in El. COGS is composed of units valued at recent prices. EI is composed of units valued at older prices.

COGS $ EI

16 units at $13 from Q4 purchases 208 5 units at $8 from OJ

14 units at $12 from Q3 purchases 168 2 units at $10 from QI purchases


8 units at $10 from QI purchases 80

50 units 588 7 units

AVCO

Under this method:

COGS is composed of units valued at average prices. EI is also composed of units valued at average prices.

$

40

20

60

Weighted average price= Value of goods available for sale Number of units available for sale

$648 I 57 = $11.37 I unit

COGS $ EI $

50 units at $11.37 568.42 7 units at $11.37 79.58

The following table summarizes the costs allocated to EI and COGS under the three cost flow assumptions:

Method BI Purchases Total EI COGS Total

FIFO $40 $608 $648 $91 $557 $648

AVCO $40 $608 $648 $79.58 $568.42 $648

LIFO $40 $608 $648 $60 $588 $648

FIFO AVCO LIFO Notice that in

Sales 1,000 1,000 1,000 periods with rising prices and stable

COGS 557 568.42 588 inventory levels, AFOresultsinthe

Gross profit 443 431.58 412 highest gross profit

©2017Wiley

INVENTORIES

Under LIFO, in periods of rising prices the prices assigned to units in ending inventory are lower than the prices assigned to units sold.

Under AVCO, regardless of whether prices are rising or falling, the prices assigned to units in ending inventory are the same as the prices assigned to units sold.

Inlhefirstyear of operations, all three methods of inventory valuation will come up with the same value for cost of goods available for sale (OJ +P).

However, in subsequent years, the cost of goods available for sale under each method would typically differ because of the different amounts allocated to opening inventory (EI in the previous year).

The total cost allocated to COGS and EI is the same across the three different COSI now methods. If one method reports higher COGS, it must report lower EI.

INVENTORIES

The difference in cash flows is the only direct economic difference that results from the choice of inventory valuation method.

Given constant or increasing inventory levels, if prices are rising over a given period (as in Example 2-1):

COGSuFO >COGS Avco> COGSFIFo EIF!Fo > EIAvco > EiuFO

Given constant or increasing inventory levels, if prices are falling over a given period:

COGSFIFo >COGS Avco> COGSuFO EiuFO > EIAvco > EIF!Fo

See Tables 1-1and1-2.

Table 1-1: LIFO versus FIFO with Rising Prices and Stable or Rising Inventory Levels

LIFO FIFO

COGS Higher Lower

Income before taxes Lower Higher

Income taxes Lower Higher

Gross profit & net income Lower Higher

Total cash flow Higher Lower

EI Lower Higher

Working capital Lower Higher

Balance Sheet Information: Inventory Account

Nakamura (Example 1-2) has seven unsold units at the end of the year. If we were to measure the true economic value or the current replacement cost of these units, we would value them at $13 each (latest prices) for an EI value of $91. FIFO ending inventory therefore reflects the replacement cost of inventory most accurately ($91 ), followed by AVCO ($79.58). The LIFO estimate for EI ($60) is farthest away from the true economic value of inventory.

© 2017Wiley

It does not matter whether prices are rising (as in our example) or falling; FIFO will always give a better reflection of the current economic value of inventory because the units currently in stock are valued at the most recent prices.

If prices are rising, LIFO and AVCO will understate ending inventory value. If prices are falling, LIFO and AVCO will overstate ending inventory value. When prices are stable, the three methods will value inventory at the same level.

Income Statement Information: Cost of Goods Sold

COGS should ideally reflect the replacement cost of inventory. The 50 units sold should each be valued at $13 (latest prices) in calculating the true replacement cost of goods sold during the year, which equals $650 (50 units x $13). LIFO estimates of COGS capture current replacement costs fairly accurately ($588), followed by AVCO ($568.42). FIFO measures of COGS ($557) are farthest away from current replacement cost of inventory.

It does not matter whether prices are rising (as in our example) or falling; LIFO will always offer a closer reflection of replacement costs in COGS because it allocates recent prices to COGS. LIFO is the most economically accurate method for income statement purposes because it provides a better measure of current income and future profitability.

If prices are rising, FIFO and AVCO will understate replacement costs in COGS and overstate profits. If prices are falling, FIFO and AVCO will overstate replacement costs in COGS and understate profits. When prices are stable, the three methods will value COGS at the same level.

©2017Wiley

INVENTORIES

The difference between the original cost of inventory and its current replacement cost is known as a holding gain or inventory profit

More information about inventory accounting methods is typically available in the footnotes to the financial

INVENTORIES

In the periodic system, the carrying value of EI and COGS is detennined only at the end of the period (periodically).

Periodic versus Perpetual Inventory Systems

Periodic inventory system: Under this system, the quantity of inventory on hand is calculated periodically. The cost of goods available for sale during the period is calculated as beginning inventory plus purchases over the period. The ending inventory amount is then deducted from the cost of goods available for sale to determine COGS.

Perpetual inventory system: Under this system, changes in the inventory account are updated continuously. Purchases and sales are recorded directly in the inventory account as they occur. The best way to understand how the perpetual system works is through an example (see Example 1-3).

Example 1-3: Illustration of Periodic and Perpetual Inventory Systems

Use Nakamura's inventory information from the previous example and employ the LIFO cost flow assumption to determine COGS and EI under the periodic and perpetual inventory systems.

PERIODIC METHOD (Assuming LIFO)

Units of Units Cost/ Units Cost of Units Inventory Ending

Purchased Unit ($) Sold Sold on Hand Inventory

Opening 5 8 5 inventory

Quarter I IO IO 13 2

Quarter 2 12 II 13 1

Quarter 3 14 12 12 3

Quarter 4 16 13 12 588 7 60 16 units@ $13/unit 5 units @ $8/unit

14 units@ $12/unit 2 units @ $10/unit

12 units@ $11/unit

8 units @ $10/unit

©2017Wiley

16>

~

0 ~ ~ ® P

ER

PE

TU

AL

ME

TH

OD

(A

ssum

ing

LIF

O)

Ope

ning

in

vent

ory

(OJ)

Qua

rter

I

Qua

rter

2

Qua

rter

3

Qu

arte

r4

Uni

ts

Co

st/

Uni

ts

Pu

rch

ased

Un

it($

) S

old

Cos

t of U

nits

Sol

d D

escr

ipti

on

5 8

10

10

12

II

14

12

16

13

13

(10

x $1

0) +

(3

x $8

) 10

uni

ts f

rom

QI

purc

hase

s =

$12

4 N

ote:

QI

purc

hase

s ar

e no

w s

old

out

3 un

its f

rom

OJ

13

(12

x$

11

)+(1

x$

8)

12un

itsf

rom

Q2p

urch

ases

=

$14

0 N

ote:

Q2

purc

hase

s ar

e no

w s

old

out

Not

e: Q

I pu

rcha

ses

are

alre

ady

sold

out

I

unit

from

OJ

12

(12

x $1

2) =

$14

4 12

uni

ts f

rom

Q3

purc

hase

s N

ote:

2 u

nits

are

lef

t fro

m Q

3 pu

rcha

ses

12

(12

x 13

) =

$15

6

Not

e: I

uni

t is

still

lef

t fro

m O

J

12 u

nits

fro

m Q

4 pu

rcha

ses

Not

e: 4

uni

ts a

re l

eft f

rom

Q4

purc

hase

s N

ote:

2 u

nits

are

stil

l lef

t fro

m

Q3

purc

hase

s N

ote:

I u

nit i

s st

ill l

eft f

rom

OJ

CO

GS

fo

r th

e y

ear

= 5

64

Uni

ts o

f In

vent

ory

on

Han

d

En

din

g I

nv

ento

ry

5 2 (2

x $

8) =

$16

(Ix

$8)

= $

8

3 (2

x $

12)

+(I

x $

8)

=$

32

7 (4

x $

13)

+ (

2 x

$12)

+ (

I x

$8)

= $

84

EI

for

the

yea

r =

84

Des

crip

tion

2 un

its f

rom

OJ

rem

ain

Not

e: Q

I pu

rcha

ses

are

sold

out

I un

it f

rom

OJ

rem

ains

2 un

its f

rom

Q3

purc

hase

s re

mai

n I

unit

fro

m O

J re

mai

ns

4 un

its f

rom

Q4

purc

hase

s re

mai

n 2

units

fro

m Q

3 pu

rcha

ses

rem

ain

I un

it f

rom

OJ

rem

ains

N

ote:

QI

and

Q2

purc

hase

s ar

e so

ld o

ut

~

!2!

§l

(jj

INVENTORIES

Conclusion

Under the LIFO cost flow assumption, in a period of rising prices, use of the periodic system for inventory results in a:

Lower ($60 versus $84) value of ending inventory. Higher ($588 versus $564) value for COGS.

Therefore, gross profit would be lower under the periodic system.

Other important takeaways from Example 1-3:

The value of sales and the cost of goods available for sale are the same under the two systems in the first year of operations. In subsequent years, the amounts of cost of goods available for sale can be different under the two systems due to different values of opening inventory (previous periods' ending inventory). If a company uses FIFO, COGS and EI are the same under the periodic and perpetual inventory systems. If a company uses separate identification, COGS and EI are the same under the periodic and perpetual inventory systems. If a company uses AVCO:

COGS and EI are the same as under FIFO and AVCO under the perpetual inventory system. COGS and EI are different from their values under FIFO under the periodic inventory system.

LESSON 2: THE LIFO METHOD AND INVENTORY METHOD CHANGES

LOS 28e: Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios. Vol 3, pp 407-418

LOS 28f: Convert a company's reported financial statements from LIFO to FIFO for purposes of comparison. Vol 3, pp 407-418

The LIFO Method and the LIFO Reserve

U.S. GAAP requires firms that use the LIFO inventory cost flow assumption to disclose the beginning and ending balances for the LIFO reserve (LR) in the footnotes to the financial statements. The LIFO reserve equals the difference between the value of inventory under LIFO, and its value under FIFO. In periods of rising prices and stable inventory levels, LIFO EI is lower than FIFO EI. Therefore,

El AFO = EI LIFO + LR ending

where LR ; LIFO reserve

© 2017Wiley

The derivation of the formula for converting COGS from LIFO to FIFO is not required. We have explained it nonetheless.

First it is important for us to understand that the choice of LIFO, FIFO, or AVCO affects only how inventory costs are allocated between EI and COGS. It does not affect purchases (P).

COGSuFO = BluFO + P - EILIFO ... (i) and COGSFIFo = BIFIFo + P - EIFIFo ... (ii)

Further:

BIF!Fo = BILIFO + LRbeginning ... (iii) and EIF!Fo = EILIFO + LRending ... (iv)

Therefore:

COGSFIFo = (B!LIFO + LRbeginningl + P - (EluFO + LRending) ... (v)

Inserting Equation (iii) in Equation (ii) Inserting Equation (iv) in Equation (ii)

COGSF!Fo = B!LIFO + LRbeginning + P - E!LIFO - LR.nding

Notice that (BluFO + P - E!LIFO) simply equals COGSLIFO [Equation (i)].

Therefore:

COGSF!Fo = LRbeginning + COGSLIFO - LR.nding COGSFIFo = COGSLIFo - (LR.nding - LRbeginning)

COGSFIFo = COGSLIFo -(Change in LR during the year)

We already know that COGSLIFO is greater than COGSFIFo in an inflationary environment. We have just learned that the difference between the two equals the change in LIFO reserve over the year.

Since COGSFIFo is lower than COGSuFo during periods of rising prices, FIFO gross profits and net income before taxes are greater than their values under LIFO by an amount equal to the change in LIFO reserve. However, net income after tax under FIFO will be greater than LIFO net income after tax by:

Change in LIFO reserve x (I -Tax rate) I

The year-end balance of the LIFO reserve represents the cumulative difference in COGS between the FIFO and LIFO cost flow assumptions over the years. Cumulative COGSFIFO will be less than cumulative COGSLIFO• and consequently, cumulative FIFO gross profits will be higher. However, the entire LIFO reserve will not be added to retained earnings when converting from LIFO to FIFO. The LIFO reserve will be divided between retained earnings (increase in equity) and taxes that have been avoided and delayed (deferred) by recording lower profits under LIFO (increase in deferred tax liabilities).

© 2017Wiley

INVENTORIES

INVENTORIES

Note that the LIFO confonnity rules require U.S . companies to use the method of inventory used for tax purposes for financial reporting as well.

When converting from LIFO to FIFO assuming rising prices:

Equity (retained earnings) increases by:

LIFO reserve x (1- Tax rate)

Liabilities (deferred taxes) increase by:

LIFO reserve x (Tax rate)

Recall the following adjustment to inventory on the balance sheet, which would also make the balance sheet balance:

Current assets (inventory) increase by:

I LIFO reserve I

The U.S. SEC has proposed the full adoption of IFRS by all U.S. reporting companies beginning in 2014 (meaning that they would no longer be able to use LIFO). As a result of the consequent restatement of financial statements (to the FIFO or weighted-average cost method), significant immediate income tax liabilities will arise. When U.S. companies actually pay out these taxes, deferred tax liabilites will fall and cash (assets) will also fall.

Example 2-1: LIFO to FIFO Conversion and Analysis

Winterfell Inc. (WNF) is a U.S. company that uses the LIFO cost flow assumption to value inventory. Assume that inventory levels have been stable and prices have gradually risen over the years. Assume tax rate of 20% for 2012 and 30% for earlier years. These assumed rates are based on the provision for taxes as a percentage of consolidated profits before taxes (as opposed to the U.S. statutory tax rate of 35%).

Income Statement 2012 2011

(Amounts in millions) $ $

Sales 21,350 17,900

COGS 16,775 14,850


Operating expenses 2,225 1,180

Operating profit 2,350 1,870

Interest expense 400 320

Earnings before taxes 1,950 1,550

Provision for income taxes 390 465

Net income 1,560 1,085

© 2017Wiley

Balance Sheet 2012 2011 2010 (Amounts in millions) $ $ $

Cash & ST investments 610 560 410

Receivables 940 1,010 740

Inventories 2,510 2,030 1,650

Total current assets 4,060 3,600 2,800

Gross fixed assets 3,020 2,130 1,750

Less: Accumulated depreciation 1,130 850 980

Net fixed assets 1,890 1,280 770

Long-term investments 3,000 3,000 2,000

Total assets 8,950 7,880 5,570

Payables 1,550 1,410 1,120

Short-term debt 650 760 790

Current portion of LT debt 1,100 970 710

Total current liabilities 3,300 3,140 2,620

Long-term debt 3,450 2,860 1,530

Total liabilities 6,750 6,000 4,150

Common stock 500 500 500

Retained earnings 1,700 1,380 920

Total shareholders' equity 2,200 1,880 1,420

Total liabilities and shareholders' equity 8,950 7,880 5,570

Notes:

LIFO reserve 1,330 1,080 960

I. What inventory values would WNF report for 2012, 2011, and 2010 if it had used FlFO instead of LIFO?

2. What would WNF's COGS for 2012 and 2011 be if it had used FlFO instead of LIFO?

3. What net income would WNF report for 2012 and 2011 if it had used FIFO instead of LIFO?

4. By what amount would WNF's 2012 and 2011 net cash flow from operating activities change if it had used FlFO instead of LIFO?

5. What is the cumulative amount of income tax savings that WNF has generated as of the end of 2012 by using LIFO instead of FIFO?

6. What amount would be added to WNF's retained earnings as of December 31, 2012, if it had used FIFO instead of LIFO?

©2017Wiley

INVENTORIES

INVENTORIES

7. What would be the change in WNF's cash balance if it had used FIFO instead of LIFO?

8. Calculate and compare the following for 2012 under LIFO and FIFO: inventory turnover ratio, days of inventory on hand, gross profit margin, net profit margin, return on assets, current ratio, and total liabilities-to-equity ratio.

Solution

I. EIFIFo = EluFo +LIFO reserve

2.

2012

El(LIFO) $2,510

LIFO reserve 1,330

EI(FIFO) $3,840

COGSFIFO = COGSuFO - (LR.,nding - LRbeginning)

2012

COGS (LIFO) $16,775

Less: Increase in LIFO reserve* (250)

COGS(FIFO) $16,525

*The increase in LIFO reserve is calculated as 1,330 - 1,080 = $250m for 2012, and as 1,080 - 960 = $ 120m for 2011.

2011 2010

$2,030 $1 ,650

1,080 960

$3,110 $2,610

2011

$14,850

(120)

$14,730

3. FIFO net income= LIFO net income+ Increase in LIFO reserve x (I - Tax rate)

Note that an increase in the LIFO reserve results in lower COGS under FIFO and an increase in operating profit.

2012

LIFO net income $1,560

Increase in LIFO reserve 250

(Increase in operating profit)

Taxes on increased operating profit* (50)

FIFO net income $1,760

*Taxes on the increased operating profit are calculated as 250 x 20% = $50m for 2012 and as 120 x 30% = $36m for 2011.

2011

$1 ,085

120

(36)

$1,169

4. Changes in the inventory cost flow assumption result in a change in the allocation of inventory costs across COGS and El, but the only cash flowrelated consequence of the change is the change in income taxes. WNF would incur an increase in income taxes amounting to $50 million in 2012 and $36 million in 2011 if it were to use the FIFO method instead of the LIFO method.

5. The cumulative amount of tax savings that WNP has generated by using LIFO instead of FIFO equals $374 million. This amount is calculated as the sum of cumulative tax savings as of 2011 (computed using a tax rate of 30%) and the incremental savings for 2012 (computed using a tax rate of20%).

Cumulative tax savings as of 2011 = $1 ,080 x 30% = $324 million. Addition tax savings for 2012 (computed in Solution 3) = $50 million.

©2017~1ey

Note that if a uniform tax rate were applicable during the entire period, we could have calculated the cumulative amount of tax savings from using LIFO as of the end of 2012 as LIFO reserve 2012 x (Tax rate).

6. The amount that would be added to WNF's retained earnings would be the cumulative increase in operating profit due to the decrease in COGS for each year. On a cumulative basis, COGS would be lower under FIFO by $1 ,330 million (LIFO reserve as of the end of 2012). However, cumulative taxes paid would be higher under FIFO by $374 million (calculated in Solution 5). Therefore, the increase in retained earnings if FIFO were used instead of LIFO would be $956 million(= 1,330--374).

7. If the FIFO method were used, an additional $374 million would have been paid in taxes, so cash would decline. If WNF were to now switch to FIFO, it would have an additional tax liability of $374 million as a consequence of the switch.

8. WNF's ratios for 2012 under LIFO and FIFO are calculated as follows:

Inventory turnover ratio = Cost of goods sold -;- Average inventory

LIFO= 16,775 7 [(2,510 + 2,030) 7 2] = 7.39 FIFO= 16,525 7 [(3 ,840 + 3,110) 7 2] = 4.76

The ratio is higher under LIFO because, given stable inventory levels and rising inventory costs, COGS would be higher and inventory carrying amounts will be lower under LIFO. If the difference in inventory methods were not taken into account, an analyst may (erroneously) conclude that a company using LIFO manages its inventory more efficiently.

Days of inventory on hand= Number of days in period 7 Inventory turnover ratio

LIFO = 365 days 7 7 .39 = 49.4 days FIFO = 365 days 7 4. 76 = 76.8 days

Again, if the difference in inventory methods were not taken into account, an analyst may (erroneously) conclude that a company using LIFO manages its inventory more efficiently.

Gross profit margin= Gross profit 7 Total revenue

LIFO = [(21 ,350 - 16,775) 7 21 ,350] = 21.43% FIFO= [(21 ,350 - 16,525) 7 21,350] = 22.60%

The gross profit margin is lower under LIFO because COGS is higher.

Net profit margin= Net income..;- Total revenue

©2017Wiley

LIFO= 1,560 7 21 ,350 = 7.31 % FIFO= 1,760 7 21,350 = 8.24%

INVENlORIES

INVENTORIES

The net profit margin is lower under LIFO because COGS is higher. However, note that the absolute percentage difference in the NP margin under the two cost flow assumptions is less than that of the GP margin because of income taxes on the higher income under FIFO.

Return on assets ;;;; Net income -:- Average total assets

LIFO= 1,560.;. [(8,950 + 7,880).;. 2] = 18.54% FIFO= 1,760.;. [(8,950 + 1,330- 374) + (7 ,880 + 1,080 - 324).;. 2] =

18.98%

Total assets are higher under FIFO (even after accounting for the cash paid for additional income taxes). The return on assets is lower under LIFO because the impact of lower net income (due to higher COGS) outweighs the impact of lower total assets (due to lower inventory carrying amounts). The company appears to be less profitable under LIFO.

Current ratio = Current assets .;. Current liabilities

LIFO = 4,060 .;. 3,300 = 1.23 FIFO= [(4,060 + 1,330 - 374).;. 3,300] = 1.52

The current ratio is lower under LIFO because of the lower carrying amount of inventory. The company appears to be less liquid under LIFO.

Total liabilities-to-equity ratio= Total liabilities.;. Total shareholders ' equity

LIFO= 6,750.;. 2,200 = 3.07 FIFO= [6,750.;. (2,200 + 956)] = 2.14

The ratio is higher under LIFO because of lower retained earnings. The company appears to be more highly leveraged under LIFO.

Notice that the company appears less profitable, less liquid, and more highly leveraged under LIFO. However, the value of the company would be higher under LIFO, as the present value of its expected future cash flows would be higher (due to lower taxes in early years). LIFO is used primarily for the tax benefits it provides in an inflationary environment.

Increase in LIFO Reserve

In every period during which prices are rising and inventory quantities are stable or rising, the LIFO reserve will increase as the excess of FIFO ending inventory over LIFO ending inventory increases.

Decline in LIFO Reserve

There can be two reasons for a decline in LIFO reserve:

I. LIFO liquidation. 2. Declining prices.

~ ©2017Wiley

LIFO Liquidation

So fat in our analysis, we have assumed stable or increasing inventory levels. LIFO liquidation occurs when a firm that uses LIFO sells more units during a given period than it purchases over the period. This causes year-end inventory levels to be lower than the beginning-of-yeat inventory levels.

When a LIFO firm sells more units than it purchases, some of the units sold are drawn from beginning inventory. We know that LIFO allocates the oldest prices to inventory, and in some cases these older prices could be extremely outdated. When a company includes older, cheaper units of stock in its COGS, it severely understates COGS, and LIFO COGS no longer reflects recent, current prices. Consequently, a firm with LIFO liquidation overstates net income. The higher profits ate unsustainable because eventually the firm will run out of cheaper, older stock to liquidate. The higher net income also comes at the cost of higher taxes that reduce operating cash flows. To postpone the taxes on holding gains on old units of inventory, a LIFO firm must always purchase as many if not more units than it sells.

Example 2-2: LIFO Liquidation

ABC, a retailer of fans, uses the LIFO cost flow assumption in the prepatation of its financial statements. What is ABC's phantom gross profit for the yeat 2007?

2004 2005 2006 2007

Uni ts purchased 100 100 100 100

Purchase price per unit $10 $11 $12 $13

Units sold 90 90 90 120

Selling price per unit $15 $16 $17 $18

COGS(LIFO) $ $ $ $

Beginning inventory 0 JOO 210 330

Purchases 1,000 l ,JOO 1,200 1,300

Goods available for sale 1,000 1,200 1,410 1,630

Ending inventory (JOO) (2JO) (330) (100)

Cost of goods sold 900 990 1,080 1,530

Income Statement (LIFO)

Sales 1,350 1,440 1,530 2,160

Cost of goods sold (900) (990) (1,080) (1,530)

Gross profit 450 450 450 630

Balance Sheet (LIFO)

Ending inventory 100 2JO 330 100

©2017Wiley

INVENlORIES

INVENTORIES

Solution

ABC has a phantom gross profit in 2007 because if ABC had purchased at least as many fans as it sold in 2007 (120 fans instead of only 100), its COGS under LIFO would have been $1 ,560 (120 units at $13 per unit) and its reported gross profit would have been $600 (sales of $2,160 minus COGS of $1 ,560). The phantom gross profit is therefore $30 (profit with LIFO liquidation of $630 minus profit without LIFO liquidation of $600).

The phantom gross profit may alternatively be calculated by multiplying the units liquidated by the difference between their replacement cost and historical cost. The total number of units liquidated equals 20 (120 units were sold while only 100 were bought). Ten of these liquidated units came from 2006 inventory while another IO came from 2005 inventory.

Holding gains recognized on 2006 liquidated units; IO x ($13 - $12); $IO Holding gains recognized on 2005 liquidated units; IO x ($13 - $11); $20 Phantom gross profit; $IO+ $20; $30.

LIFO liquidation can result from strikes, recessions, or a decline in demand for the firm's product. The irony is that when there is LIFO liquidation, the firm reports surprisingly high profits (due to the realization of holding gains on inventory) in hard times as production cuts result in the liquidation of lower-cost LIFO inventory.

Analysts should be aware that management can inflate their company's reported gross profits and net income by intentionally reducing inventory quantities and liquidating older (cheaper) units of stock. Therefore, it is important to analyze the LIFO reserve footnote disclosures to determine if LIFO liquidation has occurred. If it is found that LIFO liquidation has occurred, analysts must exclude the increase in earnings due to LIFO liquidation from their analysis. COGS must be adjusted upward for the decline in LIFO reserve, and net income must be lowered.

LIFO liquidations are more likely to occur with firms that break inventory down into numerous categories. When the different types of inventory are pooled into only a few broad categories, decreases in quantities of certain items are usually offset by increases in quantities of others.

Declining Prices

When prices of the firm 's products fall over a given period, the firm will see a decline in its LIFO reserve. If the change in LIFO reserve is negative, COGSFIFO will be greater than COGSLIFO· FIFO would continue to reflect the latest (and in this case lower) prices in inventory, and will provide the most economically accurate measure of inventory value, while LIFO would continue to reflect current replacement costs in COGS. When the reduction in LIFO reserve is caused by declining prices, no analytical adjustments are necessary.

© 2017Wiley

Inventory Method Changes

Consistency in the inventory costing method used is required under U.S. GAAP and IFRS.

Under IFRS, a change in policy is acceptable only if the change results in the provision of more reliable and relevant information in the financial statements.

Changes in inventory accounting policy are applied retrospectively. Information for all periods presented in the financial report is restated. Adjustments for periods prior to the earliest year presented in the financial report are reflected in the beginning balance of retained earnings for the earliest year presented in the report.

U.S. GAAP has a similar requirement for changes in inventory accounting policies.

However, a company must thoroughly explain how the newly adopted inventory accounting method is superior and preferable to the old one. The company may be required to seek permission from the Internal Revenue Service (IRS) before making any changes. If inventory-related accounting policies are modified, the changes to the financial statements must be made retrospectively, unless the LIFO method is being adopted (which is applied prospectively).

Analysts should carefully evaluate changes in inventory valuation methods by assessing their impact on reported financial statements. A company may justify a switch in inventory valuation method by stating that the new method better matches inventory costs with sales revenue (or some other plausible reason), but the real underlying reasons could be different. For example, a company may switch from FIFO or AVCO to LIFO to reduce income tax expense. Alternatively, it may switch from LIFO to FIFO or AVCO to increase reported profits.

Differences in inventory valuation methods should also be considered when comparing a company's performance with that of its industry or those of its competitors.

LESSON 3: INVENTORY ADJUSTMENTS AND EVALUATION OF INVENTORY MANAGEMENT

LOS 28g: Describe the measurement of inventory at the lower of cost and net realizable value. Vol 3, pp 418-425

LOS 28h: Describe implications of valuing inventory at net realizable value for financial statements and ratios. Vol 3, pp 418-425

Inventory Adjustments

Under IFRS, inventory must be stated at the lower of cost or net realizable value (NRV). NVR is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale and estimated costs to get inventory in condition for sale. If the NRV of inventory falls below the cost recorded on the balance sheet, inventory must be written down, and a loss must be recognized (as a part of COGS or separately) on the income statement. A subsequent increase in NRV would require a reversal of the previous write-down, which would reduce COGS in the period that the increase in value occurs. However, the increase in value that can be recognized is limited to the total write-down

©2017Wiley

INVENTORIES

Compare cost to NRV NRV = SP - SC

INVENTORIES

Compare cost to replacement cost (market) where: NRV - NP margin < Replacement cost< NRV

that had previously been recorded. Effectively, inventory value can never exceed the amount originally recognized.

On the other hand, U.S. GAAP requires the application of the LCM (lower of cost or market) principle to value inventory. Market value is defined as replacement cost, where replacement cost must lie within a range of values from NRV minus normal profit margin to NRV. If replacement cost is higher than NRV, it must be brought down to NRV, and if replacement cost is lower than NRV minus normal profit margin, it must be brought up to NRV minus normal profit margin. This adjusted replacement cost is then compared to carrying value (cost) and the lower of the two is used to value inventory. Any write-down reduces the value of inventory and increases COGS. Further, under U.S. GAAP, reversal of any write-down is prohibited.

An inventory write-down reduces both profit and the carrying amount of inventory on the balance sheet and thus has a negative effect on profitability, liquidity, and solvency ratios. However, activity ratios such as inventory turnover will be positively affected. Due to overall negative financial impact, some companies may be reluctant to record inventory write-downs unless the decline in value is believed to be permanent. This is especially true under U.S. GAAP where reversal of a write-down is prohibited.

Companies that use separate identification, AVCO, or FIFO inventory methods are more likely to incur inventory write-downs than companies that use LIFO. This is because LIFO values units of inventory at the oldest prices, which, given that prices are generally on the rise, results in lower carrying values for inventory. Since LIFO inventory is based on oldest and lowest costs, there is a lower chance of an inventory write-down, and if there is a write-down, it will likely be of a lesser magnitude.

In certain industries like agriculture, forest products, and mining, both U.S. GAAP and IFRS allow companies to value inventory at NRV even when it exceeds historical cost. If an active market exists for the product, quoted market prices are used as NRV; otherwise the price of the most recent market transaction is used. Unrealized gains and losses on inventory resulting from fluctuating market prices are recognized on the income statement.

Example 3-1: Accounting for Declines and Recoveries in Inventory Value

I. XYZ Company manufactures watches and prepares its financial statements in accordance with IFRS. In 2008, its carrying value of inventory was $2,500,000 before a write-down of $220,000 was recorded. In 2009, the fair value of XYZ's inventory was $400,000 greater than its carrying value.

What was the effect of the write-down on XYZ's 2008 financial statements? What is the effect of the recovery on XYZ' s 2009 financial statements, and what would be the effect of the recovery on XYZ's 2009 financial statements if XYZ's inventory were composed of agricultural products instead of watches?

Solution

In 2008, XYZ would have recorded a write-down of $220,000, which would decrease inventory asset, and increase cost of goods sold to reduce net income. For 2009, only $220,000 of the total increase in value will be recorded as a gain, which would increase inventory asset and decrease COGS to increase net income. Had XYZ's inventory been composed of agricultural products, it would have been able to record a gain of $400,000 in 2009.

©2017~1ey

2. Calculate the cost of a watch in XYZ's inventory under IFRS and U.S. GAAP given the following per-unit costs:

Original cost Estimated selling price Estimated selling costs Replacement cost Normal profit margin

Solution

$660 $700

$55 $640

$20

NRV ; Selling price - Selling costs ; $700 - $55 ; $645 NRV - Normal profit margin ; $645 - $20 ; $625

Under IFRS, inventory is reported at the lower of cost or net realizable value. The original cost ($660) exceeds the NRV ($645). Therefore, inventory is written down to its NRV, and a loss of $15 ($660 - $645) is reported on the income statement.

Under U.S. GAAP, inventory is reported at the lower of cost or market value (replacement cost). The carrying value of inventory ($660) is compared to replacement cost, where replacement cost must be adjusted so that it lies between NRV ($645) and NRV minus NP margin ($625). Since replacement cost ($640) already lies within the acceptable range it does not have to be adjusted. Because replacement cost is lower than original cost, inventory is written down to replacement cost and a loss of $20 ($660 - $640) is recorded.

3. Assume that in the year after the write-down, NRV and replacement cost both increase by $18. What is the impact of the recovery under IFRS and U.S. GAAP?

Solution

Under IFRS, the company will write up inventory to $660 and recognize a gain of $15. The write-up (gain) is limited to the original write-down of $15. The carrying value cannot exceed original cost.

Under U.S. GAAP, no write-up is allowed. The unit cost will remain at $640. XYZ will simply recognize a higher profit when inventory is sold.

©2017Wiley

INVENTORIES

lfthe NPmargin is provided in percentage terms, apply the margin to the selling price to detennine the NP margin in dollar

INVENTORIES

Example 3-2: Effects of Inventory Write-Downs on Financial Ratios

Heisenberg Labs (HBL) is a leading supplier of energy products such as solar panels and generators. Excerpts from the company's financial statements for 2011 and 2012 are provided below:

Income Statement 2012 2011 (Amounts in millions) $ $

Net sales 203,100 184,850

Cost of goods sold (149,350) (135,050)


Operating expenses (39,550) (31 ,750)

Earnings before interest and taxes 14,200 18,050

Interest income 900 800

Other expenses (1 ,500) (1000)

Earnings before taxes 13,600 17,850

Income taxes 3,400 4,463

Net income 13,388

Balance Sheet 2012 2011 (Amounts in millions) $ $

Cash and cash equivalents 9,400 8,600

Inventories M.QOOI 45,400

Receivables 5,100 5,500

Total current assets 64,500 59,500

Total noncurrent assets 200,000 150,000

Total assets 264,500 209,500

Current liabilities 145,000 115,300

Noncurrent liabilities 84,200 56,500

Total liabilities 229,200 171,800

Share capital 1,500 1,500

Reserves 3,600 1,700

Retained earnings 20,000 21,112

Income for the period 10,200 13,388

Total shareholders' equity 35,300 37,700

Total liabilities and shareholders' equity 264,500 209,500

© 2017Wiley

Excerpts from Notes to Financial Statements:

Inventories 2012 2011 (Amounts in millions) $ $

Finished products 41 ,660 35,639

Work-in progress 13,120 15,753

Raw materials 5,220 4,008

Total 60,000 55,400

Increase (decrease) in Allowance for Inventory Obsolescence 2012 2011 (Amounts in millions) $ $

Balance sheet, December 31 preceding year 2,080 1,500

Increase in allowance for inventory obsolescence 1,520 800 charged to income

Scrapping (235) (242)

Translation differences 10 2

Reclassifications, etc. (60) 20

Balance sheet, December 31 3,Jl5 -1. What inventory values would HBL have reported for 2012 and 2011 if there

were no allowance for inventory obsolescence? 2. Assuming that any changes to the allowance for inventory obsolescence are

reflected in COGS, what would HBL's COGS be for 2012 if it had not recorded any inventory write-downs during the year?

3. Assuming a tax rate of 25%, what would HBL's net income be for 2012 if it had not recorded inventory write-downs in 2012?

4. What would HBL's 2012 net income have been if it had reversed all past inventory write-downs in 2012? This question is independent of Questions 1, 2, and 3. Again, assume a tax rate of 25% for 2012.

5. Compare the following for 2012 based on the numbers as reported and those assuming no allowance for inventory obsolescence as in Questions 1, 2, and 3: inventory turnover ratio, gross profit margin, and net profit margin.

Solution

1. If no allowance for inventory obsolescence were made, then reported inventory carrying amounts would increase by the cumulative total allowance for obsolescence as of the end of the year.

©2017Wiley

INVENlORIES

INVENTORIES

Note that the total allowance for obsolescence includes the increase in allowance for obsolescence charged to income, and the effects of other items like scrapping, translation differences and reclassifications, and so on.

Total inventories, net

Allowance for obsolescence

Total inventories (without allowance)

2012

50000 ,315

53,315

2011

45,400

2,080

47,480

2. Assuming that all changes to the allowance for inventory obsolescence (including those that have actually been charged to income) are already reflected in COGS, the value of COGS would decrease by an amount equal to the increase in total allowance for obsolescence over the year if the company had not recorded any inventory write-downs.

COGS

Less: Increase in allowance for obsolescence over the year*

COGS (without allowance)

*Taxes on the increased operating profit are calculated as 3,315 x 25% = $829

2012

149,350

(1,235)

148,115

The increase in total allowance for obsolescence over 2012 is calculated as 3,315 - - ; - ·

3. If no inventory write-downs were recorded in 2012, net income would be higher by an amount equal to the increase in total allowance for obsolescence over the year, net of taxes.

Net income

Reduction in expenses (increase in operating profit)

Taxes on increased operating profit*

Net income (without allowaoce)

*Taxes on the increased operating profit are calculated as 1,235 x 25% = $309.

2012

10,200

1,235

(309)

11,126

4. If all past inventory write-downs were reversed in 2012, net income would be higher by an amount equal to the cumulative allowance for inventory obsolescence, net of taxes.

Net income

Reduction in expenses (increase in operating profit)

Taxes on increased operating profit*

Net income (after reversal of past write-downs)

2012 -3,315 (829)

12,686

© 2017Wiley

5. Inventory Turnover Ratio ; COGS .;. Average Inventory

With allowance (as reported); 149

•350

3.13 (50,000+45,400)+2

Without allowance (as adjusted); 148

•115

; 2.94 (53,315+47,480)+2

Gross Profit Margin; Gross Income.;. Net Sales


• 750

; 26.46% 203,100


• 75

0+ 1•235

27.07% 203,100

Net Profit Margin; Profit.;. Net Sales


•200

; 5.02% 203,100


•126

; 5.48% 203,100

The impact of an inventory write-down on a company's reported financial position can be substantial. Therefore, analysts should carefully evaluate the potential for any inventory write-downs and gauge their impact on financial ratios, especially if debt covenants entail financial ratio requirements. The potential for inventory write-downs tends to be higher in industries where technological obsolescence of inventories is a significant risk.

Inventory write-downs raise concerns regarding management's ability to anticipate how much and what type of inventory is required. Further, they affect a company 's future reported earnings.

The impact of an inventory write-down on a company's financial ratios is summarized in Table 3-1.

©2017Wiley

INVENTORIES

INVENTORIES

Table 3-1: Impact of an Inventory Write-Down on Various Financial Ratios

Type of Ratio

Profitability ratios

NP and GP margins

Solvency ratios

Debt-to-equity and debt ratio

Liquidity ratios

Current ratio

Activity ratios

Inventory turnover

Total asset turnover

Effect on Numerator

COGS increases so profits fall

Debt levels remain the same

Current assets decrease (due to lower inventory)

COGS increases

Sales remain the same

Effect on Denominator

Sales remain the same

Equity decreases (due to lower profits) and current assets decrease (due to lower inventory)

Current liabilities remain the same

Average inventory decreases Total assets decrease

Effect on Ratio

Lower (worsens)

Higher (worsens)

Lower (worsens)

Higher (improves)

Higher (improves)

LOS 28i: Describe the financial statement presentation of and disclosures relating to inventories. Vol 3, pg 426

Presentation and Disclosure

IFRS requires companies to make the following disclosures relating to inventory:

1. The accounting policies used to value inventory. 2. The cost formula used for inventory valuation. 3. The total carrying value of inventories and the carrying value of different

classifications (e.g., merchandise, raw materials, work-in-progress, finished goods). 4. The value of inventories carried at fair value less selling costs. 5. Amount of inventory-related expenses for the period (cost of sales). 6. The amount of any write-downs recognized during the period. 7. The amount of reversal recognized on any previous write-down. 8. Description of the circumstances that led to the reversal. 9. The carrying amount of inventories pledged as collateral for liabilities.

U.S. GAAP does not permit the reversal of prior-year inventory write-downs. U.S. GAAP also requires disclosure of significant estimates applicable to inventories and of any material amount of income resulting from the liquidation of LIFO inventory.

©2017~1ey

LOS 28j: Explain issues that analysts should consider when examining a company's inventory disclosures and other sources of information. Vol 3, pp 425-439

LOS 28k: Calculate and compare ratios of companies, including companies that use different inventory methods. Vol 3, pp 425-439

LOS 281: Analyze and compare the financial statements of companies, including companies that use different inventory methods. Vol 3, pp 425-439

Inventory Ratios

The three most important ratios used in the evaluation of a company's inventory management are the inventory turnover ratio, the number of days of inventory, and the gross profit margin:

Inventory turnover= COGS Average inventory

No. of days of inventory = 365

Inventory turnover

Gross profit margin = Gross profit Sales revenue

If a company has a higher inventory turnover ratio and a lower number of days of inventory than the industry average, it could mean one of three things:

1. It could indicate that the company is more efficient in inventory management, as fewer resources are tied up in inventory.

2. It could also suggest that the company does not carry enough inventory at any point in time, which could hurt sales.

3. It could also mean that the company might have written down the value of its inventory.

To determine which explanation holds true, analysts should compare the firm's revenue growth with that of the industry and examine the company's financial statement disclosures. A low sales growth compared to the industry would imply that the company is losing out on sales by holding low inventory quantities. A higher inventory turnover ratio combined with minimal write-downs and a sales growth rate similar to or higher than industry sales growth would suggest that the company manages inventory more efficiently than its peers. Frequent, significant write-downs of inventory value may indicate poor inventory management.

A firm whose inventory turnover is lower and number of days of inventory higher than industry average could have a problem with slow-moving or obsolete inventory. Again, a comparison with industry sales growth and an examination of financial statement disclosures would provide further information.

©2017Wiley

INVENTORIES

Evaluation of inventory management is also covered in detail in Reading 39.

INVENTORIES

The gross profit margin indicates the percentage of sales that is contributing to net income as opposed to covering the cost of sales.

Firms in relatively competitive industries have lower gross profit margins. Firms selling luxury products tend to have lower volumes and higher gross profit margins. Firms selling luxury products are likely to have lower inventory turnover ratios.

Remember that inventory ratios are directly affected by the cost flow assumption used by the company. When making comparisons across firms, analysts must understand the differences that arise from the use of different cost flow assumptions. See Example 3-3.

Example 3-3: Analysis of Inventories

The following information relates to Atlas Inc. for the years 2007 and 2008:

2007 2008

Inventory turnover ratio 6.71 6.11

Number of days of inventory 54.4 days 59.7 days

Gross profit margin 24.8% 27.3%

Current ratio 1.11 1.12

Debt-to-equity ratio 0.24 0.83

Return on total assets 1.02% -7.13%

Atlas uses the FIFO cost flow assumption to value inventory. Further, it kept stable inventory quantities during the year, while prices were gradually rising.

1. Comment on the changes in Atlas's financial statement ratios from 2007 to 2008. 2. If Atlas Inc. had used the LIFO cost flow assumption instead of FIFO, how

would the carrying values of ending inventory and COGS be different? How would its financial statement ratios change?

Solutions

1. The inventory turnover ratio declined and the number of days of inventory increased. This implies that the company has been less efficient in managing its inventory in 2008 as compared to 2007.

The gross profit margin improved by 2.5% from 24.8% in 2007 to 27 .3% in 2008.

The current ratio is relatively unchanged from 2007 to 2008.

The debt-to-equity ratio had risen significantly in 2008. This could be a result of an increase in total debt, a decrease in shareholders' equity caused by a net loss for the period, or both.

The return on assets declined significantly and was actually negative in 2008. This implies that the company made a net loss in 2008 despite the improvement in its gross profit margins over the year. This could be the result of a decrease in sales revenue, an increase in operating expenses, or both.

© 2017Wiley

2. Given that prices have been rising over the period and that inventory quantities were relatively stable, COGS would have been higher and the gross profit margin would have been lower if Atlas had used the LIFO cost flow assumption. This is because LIFO allocates the most recent (in this case higher) prices to COGS. Consequently, the company's reported gross profit, net income, retained earnings, and taxes would be lower under LIFO. (See Table 3-1.)

The carrying amount of ending inventory would be lower under LIFO because it allocates the oldest (in this case lower) prices to ending inventory.

Table 3-1: LIFO versus FlFO with Rising Prices and Stable Inventory Levels

Type of Ratio

Profitability ratios

Effect on Numerator

NP and GP margins Income is lower under LIFO because COGS is higher

Solvency ratios

Debt-to-equity and Sarne debt levels debt ratio

Liquidity ratios

Current ratio

Quick ratio

Activity ratios

Current assets are lower under LIFO because EI is lower

Quick assets are higher under LIFO as a result of lower taxes paid

Inventory turnover COGS is higher under LIFO

Total asset turnover Sales are the same

Financial Statement Analysis Issues

Effect on Denominator

Sales are the same under both

Lower equity and assets under LIFO

Current liabilities are the same

Current liabilites are the same

Effect on Ratio

Lower under LIFO

Higher under LIFO

Lower under LIFO

Higher under LIFO

Average inventory Higher under LIFO is lower under LIFO

Lower total assets Higher under LIFO under LIFO

Under both IFRS and U.S. GAAP, companies are required to disclose (either on the balance sheet or in the notes to the financial statements) the carrying amounts of inventories in classifications suitable to their business. For example, a manufacturing company may classify its inventory as production supplies, raw materials, work-inprogress (WIP), and finished goods. On the other hand, a retailer may group inventories

©2017Wiley

INVENTORIES

The values of these ratios under AVCO lie between their values under LIFO and under FIFO.

INVENTORIES

with similar attributes together. Analysts should carefully evaluate these disclosures to estimate a company's future sales and profits.

A significant increase in unit volumes of raw materials and/or WIP inventory may suggest that the company expects an increase in demand for its products. An increase in finished goods inventory with declining raw materials and WIP inventory may signal a decrease in demand for the company's products. In such cases, there may also be a possibility of future write-down of finished goods inventory. If growth in inventories is greater than the growth in sales, it could indicate a decrease in demand, which may force a company to sell its products at lower prices. Further, there may be a possibility of future write-down of inventory. Note that too much inventory also entails additional costs such as storage costs and insurance. It also means that the company has less cash and working capital available for other purposes.

A superficial comparison between inventory-related ratios of two companies (let 's say ABC and XYZ) may show that ABC has a lower percentage of assets tied up in inventory, suggesting that ABC is using its working capital more efficiently. However, if ABC were using LIFO and XYZ were using FIFO in an inflationary environment with stable or rising inventory quantities, ABC's lower ratio could be explained bits use of the LIFO cost flow assumption (inventory is carried at a lower value under LIFO in an inflationary environment), not by relative efficiency in inventory management.

Further, growth in inventory may exceed growth in sales for both ABC and XYZ, suggesting that both companies may be accumulating excess inventory. A superficial comparison of the ratio of inventory growth to sales growth for the companies may indicate that ABC's growth rate in finished goods compared to growth rate in sales is lower that XYZ's (indicating that XYZ is in more danger of being left with too much inventory). However, if ABC were using LIFO and XYZ were using FIFO in an inflationary environment with stable or rising inventory quantities, the analyst would be able to conclude that ABC's growth rate in finished goods to growth rate in sales is relatively lower (at least partially) due to its use of LIFO (which carries ending inventory at a lower value than FIFO in an inflationary environment).

To obtain additional information about a company's inventory and its expected future sales, analysts should examine the MD&A section, industry-related news and publications, and industry data. Further, when comparing financial ratios of different companies, analysts should identify any differences in inventory valuation methods, as they can have a significant impact on a company's financial statements.

© 2017Wiley

READING 29: LONG-LIVED ASSETS

LESSON 1: ACQUISITION OF LONG-LIVED ASSETS: PROPERTY, PLANT, AND EQUIPMENT AND INTANGIBLE ASSETS

Long-lived assets are expected to provide economic benefits to a company over an extended period of time, typically longer than one year_ There are three types of long-lived assets:

1. Tangible assets have physical substance, (e_g_, land, plant, and equipment)_ 2. Intangible assets do not have physical substance (e_g., patents and trademarks)_ 3. Financial assets include securities issued by other companies_

The cost of most long-lived assets is allocated over the period of time that they are expected to provide economic benefits_ The two types of long-lived assets whose costs are not expensed over time are land and intangible assets with indefinite useful lives_

LOS 29a: Distinguish between costs that are capitalised and costs that are expensed in the period in which they are incurred. Vol 3, pp 463-481

LOS 29c: Explain and evaluate how capitalising versus expensing costs in the period in which they are incurred affects financial statements and ratios. Vol 3, pp 463-481

LOS 29b: Compare the financial reporting of the following types of intangible assets: purchased, internally developed, acquired in a business combination. Vol 3, pp 463-481

Acquisition of Long-Lived Assets Upon acquisition, tangible assets with an economic life of longer than one year and intended to be held for the company's own use (e_g., PP&E) are recorded on the balance sheet at cost, which is typically the same as their fair value. Accounting for an intangible asset depends on how the asset is acquired. These assets are discussed later in the reading. If several assets are acquired as part of a group, the purchase price is allocated to each asset on the basis of its fair value.

Long-Lived Tangible Assets: Property, Plant, and Equipment (PP&E)

Capitalization versus Expensing

If an item is expected to provide benefits to the company for a period longer than one year, its cost is capitalized_ If the item is expected to provide economic benefits in only the current period, its cost is expensed.

Accounting Treatment of Capitalized Costs A capitalized cost is recognized as a non-current asset on the balance sheet. The associated cash outflow is listed under investing activities on the statement of cash flows_

©2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

In subsequent periods, the capitalized amount is allocated (expensed) over the asset 's useful life as depreciation expense (for tangible assets) or amortization expense (for intangible assets with finite lives).

o These expenses reduce net income and decrease the book value of the asset. However, since they are noncash items, depreciation and amortization do not have an impact on future cash flows (apart from a possible reduction in taxes payable). See Table 1-1.

Table 1-1: Effects of Capitalization

Initially when the cost is capitalized

In future periods when the asset is depreciated or amortized

Effects on Financial Statements

Noncurrent assets increase. Cash flow from investing activities decreases.

Noncurrent assets decrease. Net income decreases. Retained earnings decrease. Equity decreases.

Accounting Treatment of Expensed Costs A cost that is immediately expensed reduces net income for the current period by its entire after-tax amount. This hefty, one-off charge against revenues results in lower income, and lower retained earnings for the related period. The associated cash outflow is classified under operating activities on the statement of cash flows. Crucially, no related asset is recognized on the balance sheet, so no related depreciation or amortization charges are incurred in future periods. See Table l-2.

Table 1-2: Effects of Expensing

When the item is expensed


Net income decreases by the entire after-tax amount of the cost. No related asset is recorded on the balance sheet and therefore no depreciation or amortization expense is charged in future periods. Operating cash flow decreases. Expensed costs have no financial statement impact in future years.

Acquisition of Long-Lived Tangible Assets Acquired through an Exchange If an asset is acquired in a nonmonetary exchange (e.g. , exchanges of mineral leases and real estate), the amount recognized on the balance sheet typically equals the fair value of the asset acquired. In accounting for such exchanges, the carrying amount of the asset given up is removed from non-current assets on the balance sheet, the fair value of the asset acquired is added, and any difference between the two values is recognized on the income statement as a gain or a loss.

©2017Wiley

If the fair value of the asset acquired is greater than the value of the asset given up, a gain is recorded on the income statement; if the fair value of the asset acquired is lower than that of the asset given up, a loss is recorded. In rare cases, if the fair value of the acquired asset cannot be determined, the amount recognized on the balance sheet equals the carrying amount of the asset given up. In this case, no gain or loss is recognized.

Acquisition of Long-Lived Tangible Assets Acquired through a Purchase

When a long-lived asset is purchased, expenses other than the purchase price may be incurred (e.g_, costs of shipping and installation and other costs necessary to prepare the asset for its intended use).

These costs are also capitalized and included in the value of the asset on the balance sheet Subsequent expenses related to the long-lived asset may be capitalized if they are expected to provide economic benefits beyond one year, or expensed if they are not expected to provide economic benefits beyond one year. Expenditures that extend an asset's useful life are usually capitalized.

Example 1-1: Acquisition of PP&E: Capitalizing versus Expensing

Katayama Inc_ incurred the following expenses to purchase a piece of manufacturing equipment:

Purchase price (including taxes) Delivery charges Installation charges Cost of training machine maintenance staff Reinforcement of factory floor to support machine Cost of repairing factory roof Cost of painting factory walls

$15,000 55

200 300 150 500 325

Note: Factory roofrepairs are expected to extend the life of the factory by 3 years_

L Which of these expenses will be capitalized and which ones will be expensed? 2_ How will the treatment of these items affect the company's financial statements?

Solution

L All costs that are undertaken to ready the machine for its intended use must be capitalized_ Therefore, the following expenses will be capitalized by the company:

Purchase price (including taxes) Delivery charges Installation charges Reinforcement of factory floor to support machine Cost of repairing factory roof Total

$15,000 55

200 150 500

$15,905

The expenditure incurred to repair the factory roof is capitalized because it extends the useful life of the factory_

©2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

@

The following items will be expensed by the company:

Cost of training machine maintenance staff

Cost of painting factory walls

Total

$300

325

$625

The funds spent on training maintenance staff are not necessary to ready the asset for its intended use. Further, the money spent on painting factory walls is also expensed, as it does not enhance the productive capacity of the asset.

2_ The equipment-related costs that are capitalized (Le_, the purchase price, delivery charges, installation charges, and floor reinforcement costs) will be included in the carrying amount of equipment under noncurrent assets on the balance sheet. The related cash outflows will be listed under investing activities on the cash flow statement.

Capitalization versus Expensing: Impact on Financial Statements and Ratios

Example 1-2 illustrates the impact on financial statements of capitalizing versus expensing an expenditure:

Example 1-2: General Financial Statement lmpact of Capitalizing versus Expensing

Two companies, Clark Inc_ and Noon Inc_, commence operations and issue $500 of common stock for cash_ In Year 1, they each spend $450 to purchase a piece of equipment. Both companies make cash sales of $750 and incur cash operating expenses of $250 each year for 3 years_ Clark estimates the useful life of the equipment to be 3 years with zero salvage value, while Noon expenses the entire cost of the equipment in Year L Both companies are subject to a 30% tax rate_

Table 1-3 shows Clark's income and cash flow statement extracts_

Clark capitalizes the cost of the asset. Annual depreciation equals $150 (straight-line basis)_

Table 1-3: Clark Inc.

Year 1 $

Sales 750

Operating expenses (250)

Depreciation (150)

Income before tax 350

Taxes (105)

Net income 245

CFO (Net income+ Depreciation) 395

CFI (450)

Change in cash (55)

Year2 Year3 $ $

750 750

(250) (250)

(150) (150)

350 350

(105) (105)

245 245

395 395

0 0

395 395

© 2017Wiley

Table 1-4 shows Noon's income and cash flow statement extracts.

• The company expenses the entire cost of the asset in Year 1.

Table 1-4: Noon Inc.

Year 1 Year2 Year3 $ $ $

Sales 7SO 7SO 7SO Expenses (Operating expenses + Equipment cost) (700) (2SO) (2SO) Depreciation 0 0 0 Income before taxes so soo soo Taxes _(ill_ (lSO) (ISO) Net income 35 350 350

CFO (Net income + Depreciation) 3S 3SO 3SO CF! 0 0 0 Total change in cash 35 350 350

Answer the following questions:

I. Which company reports higher net income over the 3 years? 2. What is the total cash flow for the companies over the 3 years? 3. What is cash flow from operations for the companies over the 3 years? 4_ Calculate shareholders' equity for both companies for each of the 3 years. S. Compare Clark's and Noon's profitability based on their ROE and net profit

margin ratios.

Solution:

1. Total net income over the three years is the same for both companies.

Clark's net income

Noon's net income

Year I $24S

Year 1 $3S

Year2 $24S

Year2 $3SO

Year 3 $24S

Year 3 $3SO

Total $735

Total $735

Noon reports lower income in the first year because it expenses the entire cost of the equipment in Year I. Clark reports lower net income in subsequent years as it continues to depreciate the asset, whereas Noon has already written it off entirely. Lower income in Year I allows Noon to pay lower taxes in Year I. If we were to build interest income on cash savings into the analysis, Noon would benefit.

2_ Total cash flow over the 3-year period is also the same for both companies.

Clark's change in cash

Noon's change in cash

©2017Wiley

Year I - $55

Year 1 $35

Year2 $395

Year2 $350

Year3 $395

Year3 $350

Total $735

Total $735

LONG-LIVED ASSETS

LONG-LIVED ASSETS

Noon reports an increase in cash of $35 in Year I, while Clark reports a decrease in cash of $55. This is because Noon's cash taxes were $90 less than Clark's ($15 versus $105). Note that we have assumed here that the companies use the same method of depreciation for financial statement and tax purposes_ If this were not the case, deferred taxes would arise_ We will study this aspect of depreciation expense in the reading on income taxes.

3. Clark's cash flow from operating activities over the 3 years is greater than Noon's by $450 (the cost of the asset). Because Clark capitalized the cost of the equipment, it classifies it as an outflow from investing activities, not as an outflow from operating activities (as is the case with Noon).

Clark's cash flows from operations

Noon's cash flows from operations

Year I $395

Year I $35

Year2 $395

Year2 $350

Year3 $395

Year3 $350

Total $1,185

Total $735

4. Neither company pays any dividends, and there is no mention of other comprehensive income and capital contributions by shareholders_ Therefore:

5.

Retained earnings + Common stock; Total shareholders' equity

Clark

YearO Year I Retained earnings $0 $245 Common stock $500 $500 Total shareholders' equity $500 $745

Noon

YearO Year I Retained earnings $0 $35 Common stock $500 $500 Total shareholders' equity $500 $535

ROE; Net income/Average shareholders' equity

Clark

Net income Average shareholders' equity ROE

Year I $245

$622.5 39%

Year2 $490 $500 $990

Year2 $385 $500 $885

Year2 $245

$867_5 28%

Year3 $735 $500

$1 ,235

Year3 $735 $500

$1,235

Year3 $245

$1 ,112.5 22%

© 2017Wiley

Noon

Net income Average shareholders' equity ROE

Net profit margin = Net profiURevenue

Clark

Net income Revenue Net profit margin

Noon

Net income Revenue Net profit margin

Profitability analysis:

Year 1 $35

$517_5 7%

Year 1 $245 $750 33%

Year 1 $35

$750 5%

Year2 $350 $710 49%

Year2 $245 $750 33%

Year2 $350 $750 47%

Year3 $350

$1,060 33%

Year3 $245 $750 33%

Year3 $350 $750 47%

Capitalization results in higher ROE and net profit margin for Clark in Year L Expensing the entire amount in Year 1 allows Noon to report higher ROE and NP margin in subsequent years. Noon's impressive net profit margin growth from Year 1 to Year 2 (from 5% to 47%) is simply due to the expensing decision_ Its growth is not due to superior operating performance compared to Clark's_ The decision to expense also results in high variability in reported net income from year to year for Noon_

Table 1-5: Financial Statement Effects of Capitalizing versus Expensing

Capitalizing Expensing

Net income (first year) Higher Lower Net income (future years) Lower Higher Total assets Higher Lower Shareholders' equity Higher Lower Cash flow from operations activities Higher Lower Cash flow from investing activities Lower Higher Income variability Lower Higher Debt-to-equity ratio Lower Higher

All other factors remaining the same, the decision to expense an item as opposed to capitalizing it would give the impression of greater earnings growth (higher expenses in the current year followed by no related expenses in future years)_ Further, expensing allows companies to report lower taxable income in the current period and pay out lower taxes (conserving cash).

©2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

On the other hand, the decision to capitalize an item as opposed to expensing may make it easier for a company to achieve earnings targets for a particular period_ Further, capitalization allows companies to report higher operating cash flow, which is an important valuation metric.

Therefore, when making comparisons across companies, it is important to account for differences in the companies' expenditure capitalizing policies. Analysts should be wary of companies that:

Inflate reported cash How from operations by capitalizing expenditures that should be expensed. Inflate profits to meet earnings targets by capitalizing costs that should be expensed. Depress current period income by expensing costs that should be capitalized, in order to be able to exhibit impressive profitability growth going forward without any real improvement in operating performance.

Finally, note that in Example 1-2, both companies acquired a fixed asset in Year 1 only. If a company continues to purchase comparable or increasing amounts of fixed assets every year, capitalization will result in higher profits over an extended period. This would continue to be the case until the value of fixed assets purchased in a given year (amount expensed by the expensing firm) is lower than depreciation charged on capitalized assets by the capitalizing firm.

Capitalization of Interest Costs

Companies must capitalize interest costs associated with financing the acquisition or construction of an asset that requires a long period of time to ready for its intended use. For example, if a company constructs a building for its own use, interest expense incurred to finance construction must be capitalized along with the costs of constructing the building. The interest rate used to detennine the amount of interest capitalized depends on the company's existing borrowings or, if applicable, on borrowings specifically incurred to finance the cost of the asset. Under IFRS, but not U.S. GAAP, income earned from temporarily investing borrowed funds that were acquired to finance the cost of the asset must be subtracted from interest expense on the borrowed funds to determine the amount that can be capitalized.

If a company is constructing the asset for its own use, capitalized interest is included in the cost of the asset and appears on the balance sheet as a part of property, plant, and equipment. Once the asset is brought into use, the entire cost of the asset, inclusive of capitalized interest, is depreciated over time, so capitalized interest is then a part of depreciation expense, not interest expense. As a result of this accounting treatment, a company's interest costs can appear on the balance sheet (when capitalized) or on the income statement (when expensed).

If construction and sale of buildings is the core business activity of the firm and a building is constructed with the intention of selling it, capitalized interest costs are included along with costs of construction in inventory as a part of current assets. The capitalized interest is expensed as a part of COGS in the period that the building is sold.

Interest payments made prior to completion of construction that are capitalized are classified under cash flow from investing activities. Interest payments that are expensed may be classified as operating or financing cash outflows under IFRS, and are classified as operating cash outflows under U.S. GAAP.

©2017Wiley

Example 1-3: Capitalized Borrowing Costs

A company borrows $10 million to finance the construction of an office building where it expects to base its headquarters for the next 50 years. The interest rate on the loan is 6%. Construction takes 3 years, and over this period the company earns $65,000 from investing the borrowed funds in money-market instruments.

1. What amount of interest cost would the company capitalize under IFRS and under U.S. GAAP?

2_ Where will the capitalized interest costs appear on the company's financial statements?

Solution

1. Under U.S. GAAP, the company would capitalize the amount of interest paid on the loan during construction_ This amount equals ($10m x 0.06 x 3); $1,800,000_

2_ Under IFRS, the amount that can be capitalized must be adjusted for income earned from temporarily investing borrowed funds . Therefore, capitalized interest would equal $1,800,000 - $65,000; $1,735,000

o Capitalized interest will be included in the carrying amount of the asset (building) under noncurrent assets on the balance sheet.

o The amount of interest that is capitalized will appear on the cash flow statement under investing activities (during the 3 years of construction).

o Once construction is complete and the asset is in use, capitalized interest will be depreciated as a part of depreciation on the office building on the income statement.

o Once construction is complete, depreciation of capitalized interest (as a part of total depreciation) will appear on the company's cash flow statement each year if prepared using the indirect method (added to net income in the calculation of CFO)_

Analytical Issues Relating to Capitalization of Interest Costs

An analyst should consider the following issues related to capitalization of interest costs:

Capitalized interest costs reduce investing cash flow, whereas expensed interest costs reduce operating cash flow_ Therefore, analysts may want to examine the impact of classification on reported cash flows. To provide a true picture of a company's interest coverage ratio, the entire amount of interest expense for the period, whether capitalized or expensed, should be used in the denominator_ If the company is depreciating interest that was capitalized in previous years, net income should be adjusted to remove the effect of depreciation of capitalized interest.

Interest coverage ratio ; (EBIT / Interest expense)

The interest coverage ratio measures the number of times that a company's operating profits (EBIT) cover its interest expense. A higher ratio indicates that the company can comfortably service its debt through operating earnings.

©2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

Any interest costs capitalized in the current period should be treated as interest expense. Net income should be reduced by the amount of interest capitalized in the current period_

Example 1-4: Effect of Capitalized Interest Costs on Coverage Ratios and Cash Flow

Consider the following information regarding ABC Company:

2011 2010 2009

EBIT 586,225 467,350 354,300

Interest expense 59,786 43,556 23,864

Interest capitalized 10,000 3,300 7,000

Net cash flow from operating activities 15,206 15,964 15,735

Net cash flow from investing activities 52,436 (176,376) (192,363)

I. Calculate and interpret ABC's interest coverage ratio (I) as reported and (2) after adjusting for capitalized interest_ Assume that interest capitalized in previous periods increased depreciation expense by $620 in 2011, by $580 in 2010, and by $560 in 2009_

2. Comment on the effects of capitalized interest on operating and investing cash flows assuming that financial reporting does not affect reporting for income taxes.

Solution:

I. The unadjusted interest coverage ratio is calculated by dividing reported EBIT by reported interest expense.

In order to compute the adjusted interest coverage ratio we: o Adjust EBIT (upwards) for depreciation on interest capitalized in

previous years. o Add interest capitalized during the current year to interest expense_

© 2017Wiley

For each of the 3 years, interest coverage ratios with and without capitalized interest are computed in the table below:

2011 2010 2009

Interest coverage ratio $586,225 $467,350 $354,300 (based on reponed --- --- ---

$59,786 $43,556 $23,864 amounts)

=9-81 = 10.73 =14.85

Interest coverage ($586, 225 + $620) ($467,350+$580) ($354,300 + $560) ratio (adjusting for $59, 786 + $10,000 $43,556 + $3,300 $23,864+$7,000 interest capitalized)

=8.41 =9-99 =11.50

o The ratios computed above suggest that ABC's interest coverage deteriorated over the 3-year period from 2009 to 2011, even with no adjustment for capitalized interest.

o For each of the 3 years, adjustments for capitalized interest result in the adjusted interest coverage ratio being lower than the ratio computed from reported amounts. For 2009 the adjusted interest coverage ratio of 11.50 is substantially lower than the unadjusted ratio.

2. If capitalized interest had been expensed rather than capitalized, operating cash flows would have been lower in all 3 years.

o Operating cash flows would have been $8,735 for 2009, $12,664 for 2010, and $5,206 for 2011.

o This sharp decline in CFO, despite the increase in EBIT over the 3-year period, suggests that ABC's earnings may be of low quality.

Further, investing cash flows would have been higher had capitalized interest amounts been expensed.

o Investing cash flows would have been -$185,363 for 2009, -$173,076 for 2010, and $62,436 for 2011.

The example illustrates that including capitalized interest in the calculation of the interest coverage ratio provides a better assessment of a company's ability to meet its debt obligations.

Intangible Assets

Intangible assets lack physical substance and include items that involve exclusive rights such as patents, copyrights, and trademarks. Some intangible assets have finite lives, while others have indefinite lives.

The cost of an intangible asset with a finite life (e.g., patent) is amortiwd over its useful life_ The cost of an intangible asset with an indefinite life (e.g. goodwill) is not amortized; instead, the asset is tested (at least annually) for impairment. If deemed impaired, the asset's balance sheet value is reduced and a loss is recognized on the income statement.

©2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

Intangible assets can also be classified as identifiable or unidentifiable intangible assets.

Under IFRS, identifiable intangible assets must meet three definitional criteria and two recognition criteria.

Definitional criteria:

They must be identifiable. This means that they either should be separable from the entity or must arise from legal rights. They must be under the company's control. They must be expected to earn future economic benefits.

Recognition criteria:

It is probable that their expected future economic benefits will flow to the entity. The cost of the asset can be reliably measured.

An unidentifiable intangible asset is one that cannot be purchased separately and may have an indefinite life. The best example of such an asset is goodwill, which arises when one company purchases another and the acquisition price exceeds the fair value of the identifiable (tangible and intangible) assets acquired.

Accounting for an intangible asset depends on the manner of its acquisition, as described in the sections that follow.

Intangible Assets Acquired in Situations Other than Business Combinations (e.g. , Buying a Patent)

These intangible assets are recorded at their fair value when acquired, where the fair value is assumed to equal the purchase price. They are recognized on the balance sheet, and costs of acquisition are classified as investing activities on the cash flow statement. If several intangible assets are acquired as a group, the purchase price is allocated to each individual asset based on its fair value.

Companies use a significant degree of judgment to determine fair values of individual intangible assets purchased_ Therefore, analysts focus more on the types of intangible assets purchased as opposed to the value assigned to each individual asset. Understanding the types of intangible assets the company is acquiring can offer valuable insight into the company's overall strategy and future potential.

Intangible Assets Developed Internally

These are generally expensed when incurred, but may be capitalized in certain situations. Due to the differences in requirements regarding expensing/capitalizing when it comes to intangible assets developed internally versus those acquired, a company's strategy (developing versus acquiring intangible assets) can significantly impact reported financial ratios.

A company that develops intangible assets internally will expense costs of development and recognize no related assets, whereas a firm that acquires intangible assets will recognize them as assets. A company that develops intangible assets internally will classify developmentrelated cash outflows under operating activities on the cash flow statement, whereas an acquiring firm will classify these costs under investing activities.

©2017Wiley

Research and Development (R&D) Costs

IFRS requires that expenditures on research or during the research phase of an internal project be expensed rather than capitalized as an intangible asset.

Research is defined as "original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding." The research phase of an internal project refers to the period during which a company cannot demonstrate that an intangible asset is being created.

IFRS allows companies to recognize an intangible asset arising from development or the development phase of an internal project if certain criteria are met, including a demonstration of the technical feasibility of completing the intangible asset and the intent to use or sell the asset.

Development is defined as "the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use."

Generally speaking, U.S. GAAP requires that R&D costs be expensed when incurred. However, it does require that certain costs related to software development be capitalized_

Costs incurred to develop software for sale are expensed until the product's technological feasibility has been established_ Once feasibility has been established, associated development costs are capitalized. Costs related directly to the development of software for internal use are also expensed until it is probable that the project will be completed and that the software will be used as intended_ After that, related development costs are capitalized_

Note the following:

The probability that "the project will be completed" is easier to establish than "technological feasibility." The involvement of subjective judgment in detennining technological feasibility means that capitalization practices vary to a significant extent across companies. Capitalized costs related directly to developing software for sale or for internal use include the cost of employees who help build and test the software. The treatment of software development costs under U.S. GAAP is similar to the treatment of all costs of internally developed intangible assets under IFRS_

Expensing rather than capitalizing development costs results in:

Lower net income in the current period. wwer operating cash flow and higher investing cash flow in the current period_

Note that if current period software development costs exceed amortization of prior periods' capitalized development costs, net income would be lower under expensing. If, however, software development expenditures were to slow down such that current year expenses are lower than amortization of prior periods' capitalized costs, net income would be higher under expensing.

©2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

The treatment of software development costs under U.S. GAAP is similar to the treatment ofa1lcostsof internally developed intangible assets under IFRS.

Even though standards require companies to capitalize software development costs after a product's feasibility is established, judgment in detennining feasibility means that companies' capitalization practices differ.

Example 1-5: Software Development Costs

A company spends $3,000 each month during the year 2009 developing software for internal use.

I. Assuming that the company follows IFRS, how will these expenses be treated if the company is able to meet the recognition criteria on (i) May 1, 2009 and (ii) October l , 2009?

2. Assuming that the company follows U.S. GAAP, how would these expenses be classified if the company established in late 2008 that the project was going to be completed?

Solution

I. Under IFRS, the company must expense these costs until the recognition criteria are met, and capitalize them thereafter.

i. If the recognition criteria are met on May I, $12,000 worth of development expenses will be expensed on the income statement and expenses worth $24,000 will be capitalized.

ii. If the recognition criteria are met on October 1, $27,000 worth of development expenses will be expensed on the income statement and expenses worth $9,000 will be capitalized.

2. Under U.S. GAAP, expenses incurred for the development of software for internal use can be capitalized once it has been demonstrated that it is probable that the project will be completed. Therefore, all related expenses that were incurred in 2009 ($36,000) will be capitalized.

Intangible Assets Acquired in a Business Combination

When a company acquires another company, the transaction is accounted for using the acquisition method (under both IFRS and U.S. GAAP). Under this method, if the purchase price paid by the acquirer to buy a company exceeds the fair value of its net assets, the excess is recorded as goodwill.

Goodwill is an intangible asset that cannot be identified separately from the business as a whole.

Only goodwill created in a business acquisition can be recognized on the balance sheet; internally generated goodwill cannot be capitalized.

Under IFRS, acquired intangible assets are classified as identifiable intangible assets if they meet the definitional and recognition criteria that we listed earlier. If an item acquired does not meet these criteria and cannot be recognized as a tangible asset, it is recognized as a part of goodwill.

Under U.S. GAAP, an intangible asset acquired in a business combination should be recognized separately from goodwill if:

The asset arises from legal or contractual rights, or The item can be separated from the acquired company.

©2017Wiley

Examples of intangible assets treated separately from goodwill include intangible assets like patents, copyrights, franchises , licenses, and Internet domain names.

Analyst Adjustments for Variation in Capitalization Practices across Companies

Adjustments must be made to compare the financial performance of a company that expenses software development costs with that of a peer company that capitalizes these costs_ For the company that capitalizes software development costs, an analyst should make the following adjustments:

The income statement for the current period should include related software development costs as an expense and exclude amortization of development costs capitalized in prior periods_ The capitalized asset should be removed from the balance sheet (decrease assets and equity). Operating cash flow should be reduced, and investing cash flow should be increased by the amount of development costs that have been capitalized in the current period. Ratios that include income, long-lived assets, or cash flow from operations should be recalculated using adjusted values. See Example 1-6.

Example 1-6: Software Development Costs

SoftCom Inc. established technical feasibility for its first product in 2010_ Therefore, it capitalizes all related development costs. The following information is provided:

CONSOLIDATED STATEMENT OF EARNINGS For year ended December 31: 2012 2011 2010

$ $ $ Total revenue 79,250 78,350 80,100 Total operating expenses 63,100 67,845 71,270 Operating income - 10,505 8,830 Provision for income taxes 4,764 3,638 2,630 Net income 11,386 6,867 6,200

Earnings per share (EPS) 1-60 0_72 0_54

STATEMENT OF CASH FLOWS For year ended December 31: 2012 2011 2010

$ $ $ Net cash provided by operating activities - 10,685 11,356 Net cash used in investing activities* (9,350) (3,157) (3,977) Net cash used in financing activities (7 ,400) (5,538) (5 ,305) Net change in cash and cash equivalents (1 ,600) 1,990 2,074

*Includes: Software development expenses of: (_j,500] (4,200) (2,900) Car_ital exr_enditures ot (l,925) (l,400) (950)

© 2017Wiley

LONG-LIVED ASSETS

@)

LONG-LIVED ASSETS

Additional Information: For year ended December 31: 2012 2011 2010 Market value of outstanding debt 0 0 0 Amortization of capitalized software ($1,500) ($500) 0 Development expenses Depreciation expense ($2,000) ($1 ,310) ($1,017) Market price per share of common stock $50 $35 $23 Shares of common stock outstanding 7,100 9,560 11,555

The following information is disclosed in the footnotes to the financial statements: Expenses that are related to the conceptual formulation and design of software prcxiucts are expensed as incurred. Expenses that are incurred to produce the finished product after technological feasibility has been established are capitalized.

Compute the following ratios for SoftCom Inc_ based on the reported financial statements for 2012. Also compute these ratios if the company had expensed rather capitalized its investment in software. Assume the financial reporting does not affect reporting for income taxes (i.e_, there would be no change in the effective tax rate)_

A_ PIE R P/CFO c_ EVIEBITDA

Solution:

A. Based on reported financials, the PIE ratio is 31.2 (; $50-;- $1.60).

Computing the adjusted PIE ratio: o Expensing software development costs incurred during 2012 would

have reduced SoftCom's 2012 operating income by SS,500_ o Also, the company would have reported no amortization of prior years '

capitalized software development costs, which would have increased operating income by $_1_,500_

o Therefore, adjusted operating income would come in $4,000 lower at $12,150 (instead of~-

To compute the impact on earnings (and EPS) we need to detennine the company's 2012 effective tax rate and apply it to our computed operating income.

o The effective tax rate equals - -;- - ; 29_5%.

Therefore, adjusted net income equals $12,150 x (I - 0.295); $8,566 (compared to the reported $11,386)_

o EPS would therefore fall from the reported $1.60 to $1.21 (;adjusted net income of$8,566-;-7, IOO shares)_

Based on earnings adjusted to expense software development costs, the PIE ratio would be 41.3 (; $50-;- $1.21).

© 2017Wiley

B. Based on reported financials, the P/CFO ratio is 23.5 ( = $50 -o- $2.13).

o Reported CFO per share equals $2.13 (total operating cash flow of

- -o- 7,100 shares).

Computing the adjusted P/CFO ratio: The company's $5,500 expenditure on software development costs was classified as an investing cash outflow. Expensing those costs would reduce cash from operating activities by $5,500, from the reported $15,150 to $9,650.

o Adjusted CFO per share would equal $9,65017,100 = $1.36.

Therefore, based on CFO adjusted to expense software development costs, the P/CFO ratio would be 36.8 (= $50 7 $1.36).

C. Based on reported financials, the EV/EBITDA ratio is 18.1 (= $355,000 7

$19,650).

o Enterprise value is the sum of the market value of the company's equity and debt.

o The market value of equity is $355,000 (= $50 per share x 7, 100 shares) and the market value of debt is 0. Therefore, enterprise value equals $355,000.

o Reported EBITDA is $19,650 (=earnings before interest and taxes of $16,150 + $2,000 depreciation+ $1 ,500 amortization).

Computing the adjusted EV/EBITDA ratio: Assuming that capitalized software development costs are instead expensed (and that there is no amortization of prior years' capitalized development costs) EBITDA would be calculated as adjusted earnings ($12,150) plus depreciation ($2,000) plus amortization ($0), which equals $14,150.

Therefore, the adjusted EV/EBITDA ratio equals 25.1 (= $355,000 7 $14,150).

Expensing software development results in lower historical profits, operating cash flow, and EBITDA. Therefore, market multiples increase in value, giving the stock the appearance of being relatively overvalued compared to a scenario where development costs are capitalized.

© 2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

Depreciation and amortization are effectively the same concept, with the term "depreciation" referring to the process of allocating costs of tangible assets and the term "amortization" referring to the process of allocating costs of intangible assets with finite useful lives.

LESSON 2: DEPRECIATION AND AMORTIZATION OF LONG-LIVED ASSETS, AND THE REVALUATION MODEL

LOS 29d: Describe the different depreciation methods for property, plant, and equipment and calculate depreciation expense. Vol 3, pp 481-489

LOS 29e: Describe how the choice of depreciation method and assumptions concerning useful life and residual value affect depreciation expense, financial statements, and ratios. Vol 3, pp 481-489

Depreciation Methods and Calculation of Depreciation Expense

There are two primary models for reporting long-lived assets.

The cost model is required under U.S. GAAP and permitted under IFRS_ Under this model, the cost of long-lived tangible assets (except land) and intangible assets with finite useful lives is allocated over their useful lives as depreciation and amortization expense_ Under the cost model, an asset's carrying value (also called carrying amount or net book value) equals its historical cost minus accumulated depreciation/amortization (as long as the asset has not been impaired). Impairment is discussed later in the reading_

The revaluation model is permitted under IFRS, but not under U.S. GAAP_ Under this model, long-lived assets are reported at fair value (not at historical cost minus accumulated depreciation/amortization).

Depreciation methods include the straight-line method, accelerated methods, and the unitsof-production method_

Straight-Line Depreciation

Under the straight-line method, the cost of the asset is allocated evenly across its estimated useful life.

Depreciation expense is calculated as depreciable cost divided by estimated useful life.

Depreciable cost is the historical cost of the tangible asset minus the estimated residual (salvage) value. The residual value is the estimated amount that will be received from disposal of the asset at the end of its useful life_

Depreciation expense= Original cost - Salvage value Depreciable life

Accelerated Depreciation

Under accelerated depreciation methods, the allocation of depreciable cost is greater in the early years of the asset's use.

A commonly used accelerated method is the declining balance method in which the amount of depreciation expense for a period is calculated as some percentage of the carrying amount (i_e., cost net of accumulated depreciation at the beginning of the period)_

© 2017Wiley

When an accelerated method is used, depreciable cost is not used to calculate depreciation expense, but the carrying amount should not be reduced below the estimated salvage value.

Double declining balance depreciation= 2

x Beginning book value Depreciable life

Units-of-Production Method

Under the units-of-production method, the amount of depreciation expense for a period is based on the proportion of the asset 's production during the period compared with the total estimated productive capacity of the asset over its useful life.

Depreciation expense is calculated as depreciable cost times production in the period divided by estimated productive capacity over the life of the asset.

Example 2-1 illustrates the three depreciation methods_

Note that regardless of the depreciation method used, the carrying amount of the asset is not reduced below the estimated residual value_

Example 2-1: Depreciation Methods

Three companies, Company A, Company B, and Company C, purchase an identical piece of manufacturing equipment for use in their operations_ The cost of the equipment is $3,000, the estimated salvage value is $200, and the useful life of the equipment is 4 years. Further, the total production capacity of the equipment over its useful life equals 1,000 units. Each company earns $3,500 in revenues, and incurs expenses of $1,500 (excluding depreciation) every year_ The companies are subject to a tax rate of 30%_ Actual output levels of each of the companies over the 4 years are:

2 3 Year Production (units) 300 400 200

Company A uses the straight-line method of depreciation. Company B uses the double declining method_ Company C uses the units-of-production method.

4 100

I. Calculate each company's beginning net book value, annual depreciation expense, end-of-year accumulated depreciation, and ending net book value for each year_

2. Explain the differences in the timing of recognition of depreciation expense between the companies.

3. Calculate each company's net profit margin for each of the 4 years. Also evaluate the impact of depreciation methods on this ratio_

© 2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

Solution:

1. Company A uses straight-line depreciation. Therefore, its annual depreciation expense equals $700 [($3,000 - $200) I 4 years].

Beginning book value in Year I equals the historical cost or purchase price.

Accumulated year-end depreciation equals total depreciation charged against the asset till the end of the current period.

Year 3 accumulated depreciation = Accumulated depreciation at the end of Year 2 +Year 3 depreciation expense = $1,400 + $700

i

Ending net book value equals historical cost minus accumulated depreciation or beginning book value minus depreciation expense.

i Beginning Ending

Book Depreciation Accumulated Net Book Value Expense Depreciation Value

$ $ $ $

Year I ~ 3,000 700 700 2,300

Year2 2,300 700 1,400 1,600

Year3 1,600 700 2,100 900

Year4 900 700 2,800 200

CompanyB

Under the double declining balance (DOB) method, the depreciation rate is double the depreciation rate under the straight-line method. The depreciation rate under the straight-line method is 25% (= 100%/4). Therefore, the rate under the double declining balance method is 50% ( = 2 x 25% ). Recall that annual depreciation expense under this method is computed based on the carrying amount, not on the depreciable cost.

Depreciation charges:

Year I = (2/4) x $3,000 = $1,500

Year 2 = (2/4) x $1,500 = $750

Year 3 = (2/4) x $750 = $375

Year4 = (2/4) x $375 = $187.50.

Note that since a depreciation charge of $187.50 in Year 4 would take the year-end carrying amount of the asset to $187.50, which is less than its salvage value, the amount of depreciation charged would be only $175 (as a charge of $175 would take the carrying amount to the salvage value).

©2017~1ey

Beginning Net Book Depreciation Accumulated

Value Expense Depreciation $ $ $

Year 1 3,000 1,500 1,500

Year2 1,500 750 2,250

Year3 750 375 2,625

Year4 375 175 2,800

CompanyC

Depreciation expense per unit= ($3,000 - $200) $2_80/unit 1,000 umts

Yearl Year2 Year3

Production (units) 300 400 200

Depreciation expense 840 1,120 560

Beginning Net Book Accumulated

Value Depreciation Depreciation $ Expense$ $

Year 1 3,000 840 840

Year2 2,160 1,120 1,960

Year3 1,040 560 2,520

Year4 480 280 2,800

Ending Net Book

Value $

1,500

750

375

200

Year4

100

280

Ending Net Book

Value $

2,160

1,040

480

200

2_ All 3 methods result in the same total depreciation expense over the life of the equipment ($2,800). The difference between the methods lies in the timing of recognition of total depreciation expense across the years_ The straight-line method recognizes the expense evenly over the asset's life, the DDB method recognizes most of the expense in the first year, and the units-of-production method recognizes depreciation expense based on actual usage over each period_ Under all 3 methods, the book value of equipment at the end of its useful life equals $200_

© 2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

3_ Calculation of net profit margin

Year 1 Year2 Year3 Year4 Company A $ $ $ $ Revenues 3,500 3,500 3,500 3,500 Expenses (1,500) (1,500) (1,500) (1 ,500) Depreciation (700) (700) (700) (700) Net income before tax 1,300 1,300 1,300 1,300 Taxes (390) (390) (390) (390) Net income ~ ~ ~ ~

Net profit margin 26% 26% 26% 26%

CompanyB Year 1 Year2 Year3 Year4

Revenues 3,500 3,500 3,500 3,500 Expenses (1 ,500) (1 ,500) (1 ,500) (1,500) Depreciation (1,500) (750) (375) (175) Net income before tax -----soo 1,250 ~ ~ Taxes (150) (375) (487.50) (547_50) Net income ~ ----s75 1,137.50 1,277.50

Net profit margin 10% 25% 32.5% 36.5%

Year 1 Year2 Year3 Year4 CompanyC $ $ $ $ Revenues 3,500 3,500 3,500 3,500 Expenses (1,500) (1,500) (1,500) (1 ,500) Depreciation (840) (1,120) (560) (280) Net income before tax 1,160 880 1,440 1,720 Taxes (348) (264) (432) (516) Net income ---SU ~ 1,008 1,204

Net profit margin 23.2% 17.6% 28.8% 34.4%

Analysis:

Company A reports tbe same net income before tax, net income, and net profit margin in each of tbe 4 years_ Company B reports lower net income before tax, net income, and net profit margin in tbe first year_ Company C's net profit margin varies with production levels.

In tbe early years of tbe asset's life, use of an accelerated depreciation method results in lower pretax income, taxes payable, and net profit margin than when straight-line depreciation was used.

In several countries, including tbe United States, companies are allowed to use different depreciation methods on their financial statements and their tax returns.

© 2017Wiley

Comparison between Straight-Line and Accelerated Depreciation Methods

All other factors remaining the same, a company that uses the straight-line method to depreciate its assets will report:

A lower asset turnover ratio during the early years of the asset's use (because a lower depreciation charge results in higher net assets). Higher operating profit margin in the early years of the asset's use (because lower depreciation expense results in higher operating income). Higher operating return on assets (ROA) in the early years of the asset's use (due to lower depreciation expense) and lower ROA in later years_

Further, a company that uses an accelerated depreciation method will report an improving asset turnover ratio, operating profit margin, and ROA over time. Therefore, it is important to understand that the different depreciation methods used by companies in the same industry can influence their trends in ratios over time and result in significant differences in their reported financial performance.

On the balance sheet, companies may present the total net amount of property, plant, and equipment and the total net amount of intangible assets. More details are usually disclosed in the notes to the financial statements. These details typically include:

Acquisition costs. Depreciation and amortization expenses. Accumulated depreciation and amortization. Depreciation and amortization methods used. Information on assumptions used to depreciate and amortize long-lived assets.

Estimates Used for Calculating Depreciation

Assumptions of a longer useful life and a higher expected residual value result in lower annual depreciation expense compared to assumptions of a shorter useful life and a lower salvage value. The subjective nature of these assumptions allows management to manipulate earnings.

Management could significantly write down the value of long-lived assets and recognize a hefty charge against net income in the current period. While this would depress earnings in the current year, it would allow management to recognize lower annual depreciation expense going forward, inflate profits, and report impressive growth in profitability.

Management could also overstate the useful life and the salvage value of an asset to show impressive profits over the near term, and recognize a significant loss at a later point in time when the asset is eventually retired.

Additional assumptions are required to allocate depreciation expense between cost of goods sold (COGS) and selling, general, and administrative expenses (SG&A). Including a higher proportion of total depreciation expense in COGS lowers the gross profit margin and lowers operation expenses. However, it does not affect the net profit margin.

Companies should review their estimates and assumptions regarding depreciation periodically to ensure that they are reasonable. IFRS requires companies to review estimates annually.

©2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

There are no significant differences between IFRS and U.S. GAAP regarding the definition of depreciation and acceptable depreciation methods_ However, IFRS requires companies to use the component method of depreciation_ Under this method, companies depreciate different components of assets separately (using estimates for each component). Under U.S. GAAP, this method is allowed but not widely used_ See Example 2-2_

Example 2-2: Component Method of Depreciation

A company purchases a machine with an expected useful life of 10 years and an estimated salvage value of $2,000 for $10,000; $4,000 of the cost of the machine represents the cost of the wheel, which is a significant component of the machine. The company estimates that the wheel will need to be replaced every 2 years. Answer the following questions assuming that the wheel has zero salvage value and that the company uses straight-line depreciation for all assets_

L How much depreciation would the company record for Year I if it uses the component method, and if it does not use the component method?

2_ Assuming that a new wheel is purchased at the end of Year 2, how much depreciation would the company record (in Year 3) if it uses the component method, and if it does not use the component method?

3_ Assuming that wheel is replaced every 2 years for $4,000, what is the total amount of depreciation charged over the 10 years if the company uses the component method, and if it does not use the component method?

4_ Which additional estimates must be made if the company chooses to use the component method instead of depreciating the machine as a whole?

Solution

L If the company does not use the component method, it would charge depreciation of $800 in Year I .

Calculation: ($10,000-$2,000) / 10 = $800

Under the component method, depreciation expense for Year I would be calculated as:

[($6,000-$2,000) / 10] + ($4,000 / 2) = $2,400

2_ If a new wheel is purchased at the end of Year 2, depreciation expense for Year 3 if the component method were not used is calculated as:

[($10,000-$2,000) / 10]+($4,000 / 2) = $2,800

Depreciation expense under the component method would be calculated as:

[($6,000-$2,000) I 10] + ($4,00012) = $2, 400

© 2017Wiley

J_ If the company does not use the component method, total depreciation charged over the IO years, assuming that the wheel is replaced every 2 years, is calculated as:

($800 x 2) + ($2,800 x 8) = $24,000

Under the component method, total depreciation charged over the IO years is calculated as:

$2, 400 x IO = $24,000

Note that the same amount of total depreciation is charged over the entire life of the asset under both methods_

4_ If the company elects to depreciate the asset using the component method (as opposed to depreciating it as a whole), it must make the following assumptions in addition to the useful life and residual value of the machine:

i. Portion of machine cost attributable to the wheel. ii. Portion of residual value attributable to the wheel.

iii . Useful life of wheel.

Total depreciation expense may be allocated between COGS and other expenses. Depreciation expense of assets used in production is usually allocated to COGS, while depreciation expense of assets used in other functional areas may be allocated to some other expense category (e_g_, SG&A)_

LOS 29f: Describe the different amortisation methods for intangible assets with finite lives and calculate amortisation expense. Vol 3, pp 489-490

LOS 29g: Describe how the choice of amortisation method and assumptions concerning useful life and residual value affect amortisation expense, financial statements, and ratios. Vol 3, pp 489-490

Amortization Methods and Calculation of Amortization Expense

Intangible assets with finite useful lives are amortized over their useful lives. This results in the cost of these assets being "matched" with the benefits that accrue from them_ Examples of intangible assets with finite useful lives include:

An acquired patent or copyright with a specific expiration date. Customer lists acquired by a direct mail marketing company that are expected to provide future economic benefits. An acquired license with a specific expiration date with no associated right to renew the license. An acquired trademark for a product that a company plans to phase out over a specific number of years_

©2017Wiley

LONG-LIVED ASSETS

Total depreciation overthelifeofthe asset under both methods equals total expenditure on assets adjusted for any salvage value.

LONG-LIVED ASSETS

Assets assumed to have an indefinite useful life are not amortized_ An intangible asset is considered to have an indefinite useful life when there is "no foreseeable limit to the period over which the asset is expected to generate net cash inflows" for the company_

Acceptable amortization methods are the same as acceptable depreciation methods. Similar to the estimates required to calculate depreciation expense of tangible fixed assets, the estimates required to calculate yearly amortization expense for an intangible fixed asset with a finite life are:

The original value of the intangible asset. The residual value at the end of its useful life. The length of its useful life. See Example 2-3.

Example 2-3: Calculation of Amortization Expense

Gluco Pharmaceuticals acquired another company during 2011 and reported the following intangible assets at the end of the year:

Patent= $950,000 Operating license = $500,000 Copyright= $500,000 Goodwill= $1,200,000

The following information is also available:

The patent will expire in 10 years. The company expects to sell the copyright in 5 years for an estimated amount of $100,000. The license will expire in 5 years, but can be renewed at no cost.

Given that the company uses the straight-line method for amortizing its intangible assets, calculate the total value of intangible assets on the company's 2012 balance sheet.

Solution:

Goodwill is not amortized. It must be checked for impairment (at least annually). The operating license is an intangible asset with an indefinite life, as the company retains the right to renew the license at little or no cost. If the license had a specific expiration date, or if the company did not have the right to renew the license, Gluco would have to amortize the value of the license over its useful life. Amortization of patent= $950,000 I 10 = $95,000

o The patent is an identifiable intangible asset with a finite life. It is amortized over its useful life.

Amortization of copyright= [($500,000 - 100,000) I 5] = $80,000 o The copyright is an identifiable intangible asset with a finite life. Its

"amortizable value" is amortized over its useful life.

@ © 2017Wiley

Therefore, Gluco's 2012 balance sheet will reflect the following values for its intangible assets:

Patent= $950,000 - 95,000 = $855 ,000 Copyright = $500,000 - 80,000 = $420,000 Goodwill= $1,200,000 Operating license = $500,000

LOS 29h: Describe the revaluation model. Vol 3, pp 490-494

LOS 29k(i): Explain and evaluate how revaluation of property, plant, and equipment and intangible assets affect financial statements and ratios. Vol 3, pp 490--494

The Revaluation Model

IFRS allows companies to use the revaluation model or the cost model (where the carrying amount of an asset equals its historical cost minus accumulated depreciation/amortization) to report the carrying amounts of non-current assets on the balance sheet. Revaluation results in the carrying amount of an asset reflecting its fair value (as long as it can be measured reliably). Under the revaluation model, the carrying amount of an asset is reported at its fair value on the date of revaluation minus any subsequent accumulated depreciation and subsequent impairment. However, revaluations must be made frequently enough so that the carrying value of the asset does not materially deviate from its fair value. For practical purposes, the revaluation model is rarely used for either tangible or intangible assets, but its use is especially rare for intangible assets. Under U.S. GAAP, only use of the cost model is permitted_

A key difference between the revaluation and the cost model is that revaluation allows for the reported value of the asset to be higher than its historical cost. Under the cost model, by contrast, the reported value of an asset can never exceed its historical cost.

IFRS allows the revaluation model to be used for certain classes of assets and for the cost model to be used for others as long as (1) the company applies the same model to assets in a particular class (e.g., land and buildings, machinery, factory equipment, etc.) and (2) whenever a revaluation is performed, all assets in the particular class are revalued (to avoid selective revaluation)_

The effects of an asset revaluation on the financial statements depend on whether a revaluation initially increases or decreases the asset's carrying value.

If a revaluation initially decreases the carrying amount of an asset:

The decrease in value is recognized as a loss on the income statement. Later, if the value of the asset class increases:

o The increase is recognized as a gain on the income statement to the extent that it reverses a revaluation loss previously recognized on the income statement against the same asset class.

o Any increase in value beyond the reversal amount will not be recognized on the income statement, but adjusted directly to equity through the revaluation surplus account.

LONG-LIVED ASSETS

©2017Wiley @

LONG-LIVED ASSETS

Clearly, the use of the revaluation mcxlel as opposed to the cost model can have a significant impact on the financial statements of companies. This has potential consequences for comparing financial perfonnance using financial ratios of companies that use different models.

If a revaluation initially increases the carrying amount of an asset:

The increase in value bypasses the income statement and goes directly to equity through the revaluation surplus account. Later, if the value of the asset class decreases:

o The decrease reduces the revaluation surplus to the extent of the gain previously recognized in the revaluation surplus against the same asset class_

o Any decrease in value beyond the reversal amount will be recognized as a loss on the income statement.

If an asset is sold or disposed of, any associated revaluation surplus recognized in other comprehensive income is transferred directly to retained earnings_

Example 2-4: Asset Revaluation

A company purchases an asset for $10,000_ After one year, it determines that the value of the asset is $8,000 and another year later it determines that the fair value of the asset is $15,000. Assuming that the company follows the revaluation model to report this asset, describe the financial statement impact of the revaluation in Year I and Year 2_

Solution

At the end of Year I , the company will report the asset at its fair value ($8,000). The decrease in its value ($2,000) will be charged as a loss on the income statement.

At the end of Year 2, the company will report the asset at its fair value ($15,000). The increase in value from the Year I value ($8,000) to the historical cost ($10,000) will essentially be reversing the previously recognized write-down (in Year I). Therefore, a gain of $2,000 will flow through the income statement in Year 2. The remaining increase in value ($5,000) from the historical cost to the current fair value (end of Year 2) will bypass the income statement and will be recorded directly on the balance sheet under shareholders ' equity in the revaluation surplus.

Example 2-5: Asset Revaluation

A company purchases an asset for $5,000_ After one year, it determines that the value of the asset is $7 ,700 and another year later it determines that the fair value of the asset is $2,400. Assuming that the company follows the revaluation model to report this asset, describe the financial statement impact of the revaluation in Year I and Year 2_

Solution

At the end of Year I , the company will report the asset at its fair value ($7,700). The increase in its value ($2,700) will be recorded directly on the balance sheet under shareholders ' equity in the revaluation surplus.

At the end of Year 2, the company will report the asset at its fair value ($2,400). The decrease in value from the Year I value ($7,700) to the historical cost ($5,000) will essentially be reversing the previously recognized increase in value (in Year I). Therefore, the revaluation surplus (shareholders' equity) will be reduced by $2,700. The remaining decrease in value ($2,600) from the historical cost to the current fair value (end of Year 2) will be recorded as a loss on the income statement.

© 2017Wiley

Considerations for Financial Analysis

Asset revaluations require many considerations for financial statement analysis.

An increase in the carrying value of depreciable long-lived assets increases total assets and shareholders' equity_ Hence, revaluation of assets can be used to reduce reported leverage (financial leverage ratio= average total assets/average shareholders' equity)_

o Even though assets and equity increase by the same amount, the percentage increase in assets is lower than the percentage increase in equity (assets are typically greater than equity since A = L + E). As a result, the denominator (equity) effect dominates and the ratio falls, making the company appear more solvent.

If a company is seeking new capital or approaching leverage limitations set by financial covenants, it may choose to revalue its assets upward to present more favorable solvency levels.

Asset revaluations that decrease the value of an asset also decrease net income in the year of revaluation. In the year of revaluation, return on assets (net profit/ assets) and return on equity (net profit/shareholders' equity) decline. (The percentage change in the numerator is greater than the percentage change in the denominator, so the numerator effect dominates.) In future years, however, the lower values of assets and equity may result in higher ROA and ROE. Further, reversals of downward revaluations also go through income. Managers can then opportunistically time the reversals to manage earnings and increase income. If the carrying value of the asset is increased in a revaluation, assets and equity increase, and annual depreciation expense also increases. As a result, performance measures such as ROA and ROE may decline in the future. This is ironic given that an upward revaluation is usually associated with an improvement in the operating capacity of the asset and is beneficial for the company. Analysts should also look into who performs asset value appraisals and how often revaluations are recognized. Regular appraisals can be good because the reported value of the asset is representative of its fair value. Appraisals performed by independent external sources are more reliable.

LESSON 3: IMPAIRMENT OF ASSETS, DERECOGNITION OF ASSETS, PRESENTATION AND DISCLOSURES, AND INVESTMENT PROPERTY

LOS 29i: Explain the impairment of property, plant, and equipment and intangible assets. Vol 3, pp 494--496

LOS 29j: Explain the derecognition of property, plant, and equipment and intangible assets. Vol 3, pp 497-499

LOS 29k(i): Explain and evaluate how impairment, and derecognition of property, plant, and equipment and intangible assets affect financial statements and ratios. Vol 3, pp 494--499

©2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

Impairment of Assets

An impairment charge is made to reflect the unexpected decline in the fair value of an asset Impairment recognition has the following effects on a company's financial statements:

The carrying value of the asset decreases. The impairment charge reduces net income_ Impairment does not affect cash flows, because it is a noncash charge_

Both IFRS and U.S. GAAP require companies to write down the carrying amount of impaired assets_ Impairment reversals are permitted under IFRS but not under U.S. GAAP.

Impairment of Property, Plant, and Equipment

Companies are required to assess whether there are indications of impairment of property, plant, and equipment at the end of each reporting period. If there are no suggestions of impairment, the asset is not tested for impairment However, if there are indications of impairment, the recoverable amount of the asset must be measured in order to test the asset for impairment Indications of impairment include evidence of obsolescence, decrease in demand for the asset 's output, and technological advancements_

A company must recognize an impairment loss when the asset 's carrying value is higher than its recoverable amount Impairment losses reduce the carrying amount of the asset on the balance sheet and reduce net income (and shareholders ' equity)_ Note that impairment does not affect cash flows_

Under IFRS, an asset is considered impaired when its carrying amount exceeds its recoverable amount. The recoverable amount equals the higher of "fair value less costs to sell" and "value in use," where value in use refers to the discounted value of future cash flows expected from the asset The impairment loss that must be recognized equals the carrying amount minus the recoverable amount.

Under U.S. GAAP, determining whether an asset is impaired is different from measuring the impairment loss. An asset is considered impaired when its carrying value exceeds the total value of its undiscaunted expected future cash flows (recoverable amount). Once the carrying value is determined to be nonrecoverable, the impairment loss is measured as the difference between the asset 's carrying amount and its fair value (or the discounted value of future cash flows, if fair value is not known). See Example 3-1.

Example 3-1: Impairment of Property, Plant, and Equipment

Susan Inc_ owns a piece of equipment that has a carrying value of $3,000_ The demand for the products manufactured by this piece of equipment has fallen drastically. The company estimates that the total expected future cash flows from this piece of equipment would amount to $3,200, and the present value of these expected cash flows is $2, 700_ The company estimates that the fair value of the asset is $2,800 and selling costs would amount to $200_

L Under IFRS, what would be the carrying amount of the machine and how much impairment would be charged against it?

2_ Under U.S. GAAP, what would be the carrying amount of the machine and how much impairment would be charged against it?

@ ©2017Wiley

Solution

L The carrying amount of the machine must be compared to the higher of fair value less costs to sell ($2,600) and value in use ($2,700). The carrying amount ($3 ,000) is greater than the asset's value in use ($2,700), so the asset's value is written down to $2,700 and an impairment charge worth $300 is recognized on the income statement. Depreciation for future years would be based on the new carrying value of $2,700.

2_ The carrying amount of the machine ($3,000) is less than the total undiscounted cash flows expected from the asset in the future ($3 ,200). Therefore, the asset is not considered impaired and no impairment charge is made on the income statement for the period.

Impairment of Intangible Assets with a Finite Life

Intangible assets with finite lives are amortized_ These assets are not tested for impairment annually (unlike intangible assets with indefinite lives); they are tested for impairment only upon the occurrence of significant adverse events (e.g., a significant decrease in market price or adverse changes in legal and economic factors). Accounting for impairment of these assets is essentially the same as accounting for impairment of property, plant, and equipment.

Impairment of Intangibles with Indefinite Lives

Goodwill and other intangible assets with indefinite lives are not amortized_ They are carried on the balance sheet at historical cost and tested at least annually for impairment. Impairment must be recognized when carrying value exceeds fair value_

Impairment of Long-Lived Assets Held for Sale

A long-lived asset is reclassified from being an asset "held-for-use" to an asset "held-forsale" when it is no longer in use and management intends to sell it. These assets are tested for impairment when they are categorized as held-for-sale. If it is found that the carrying value exceeds their fair value less selling costs, an impairment loss is recorded and their carrying value is brought down to fair value less selling costs_ Once classified as held-forsale, these assets are no longer depreciated or amortized by the company.

Reversals of Impairments of Long-Lived Assets

Under U.S. GAAP, once an impairment loss is recorded for assets held-for-use, it cannot be reversed_ However, for assets held-for-sale, if the fair value of the asset increases subsequent to impairment recognition, the loss can be reversed and the asset's value can be revised upward_

IFRS allows reversal of impairment losses if the value of the asset increases regardless of classification of the asset. Reversal of a previously recognized impairment charge increases reported profits_ Note that IFRS allows reversals of only impairment losses. It does not allow the value of the asset to be written up to a value greater than the previous carrying amount even if the new recoverable amount is greater than the previous carrying value_

© 2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

A significant degree of subjective judgment is involved in projecting future cash flows from assets, and in assessing fair values_ This affords management considerable discretion relating to the amount and timing of impairment recognition. Therefore, analysts must carefully examine impairment charges when analyzing past performance of companies and in projecting performance going forward.

Derecognition

A company derecognizes or removes an asset from its financial statements when the asset is disposed of or is not expected to provide any future economic benefits from use or disposal. A company can dispose of a long-lived operating asset by selling it, by exchanging it for another asset, or by abandoning it.

Sale of Long-Lived Assets

The gain or loss on sale of a long-lived asset is computed as:

Gain/(loss) on asset disposal = Selling price- Carrying or book value of asset

Carrying or book value= Historical cost - Accumulated depreciation

A gain or loss on the sale of a fixed asset is disclosed on the income statement either as a component of other gains and losses (if the amount is insignificant) or as a separate line item (if the amount is significant). Gains and losses on disposal of fixed assets can also be found on the cash flow statement if prepared using the indirect method. Recall that the effect of fixed asset disposal-related gains and losses are removed from net income (because they relate to non-operating activities) to compute cash flow from operating activities under the indirect method. Further, the amount of proceeds from sale are included in cash flow from investing activities. A company may disclose further details about the sale of long-lived assets in the management discussion and analysis (MD&A) section and/or financial statement footnotes.

Long-Lived Assets Disposed of Other than by a Sale

Long-lived assets intended to be disposed of other than by a sale (e.g., abandoned, exchanged for another asset, or distributed to owners in a spin-off) are classified as held for use until disposal. Just like other noncurrent assets held by the company, they continue to be depreciated and tested for impairment until actual disposal.

When an asset is retired or abandoned, the company does not receive any cash for it. Assets are reduced by the carrying value of the asset at the time of retirement or abandonment, and a loss equal to the asset's carrying amount is recorded on the income statement.

When an asset is exchanged for another asset, the carrying amount of the asset given up is removed from the company's balance sheet, and replaced by the fair value for the asset acquired. Any difference between the carrying amount and the fair value is recognized as a gain or loss on the income statement. Note that the fair value used is the fair value of the asset given up unless the fair value of the asset acquired is more clearly evident. If no reliable measure off air value exists, the acquired asset is measured at the carrying amount of the asset given up.

©2017Wiley

In a spin-off, an entire cash-generating unit of a company is separated into a new entity, with shareholders of the parent company receiving a proportional number of shares in the new company_ All the assets of the new entity are removed from the balance sheet of the parent at the time of the spin-off.

LOS 291: Describe the financial statement presentation of and disclosures relating to property, plant, and equipment and intangible assets. Vol 3, pp 499-509

LOS 29m: Analyze and interpret financial statement disclosures regarding property, plant, and equipment and intangible assets. Vol 3, pp 499-509

Presentation and Disclosures

Disclosures: Tangible Assets

IFRS

• The measurement bases used. • The depreciation method used_ • Useful lives (or depreciation rate)_ • Accumulated depreciation at the beginning

and end of the period_ • Restrictions on title. • Pledges of property as security. • Contractual agreements to acquire PP&E. • If the revaluation model is used, the company

must disclose: o The date of revaluation_ o Details of fair value detemtination. o The carrying amount under the cost model. o Amount of revaluation surplus_

©2017Wiley

U.S.GAAP

• Depreciation expense for the period.

• The balances of major classes of depreciable assets_

• Accumulated depreciation by major classes or in total.

• General description of depreciation methods used for major classes of depreciable assets.

LONG-LIVED ASSETS

A comprehensive example discussing the financial statement presentation and disclosures relating to PP&E and intangible assets is included in the practice questions.

LONG-LIVED ASSETS

Disclosures: Intangible Assets

IFRS

• fur each class of intangible assets whether they have a finite or indefinite life. o If finite, for each class disclose:

• The useful life (or amortization rate).

• The amortization methods used. • The gross carrying amount. • Accumulated amortization at the

beginning and end of the period. • Where amortization is included

on the income statement. • Reconciliation of carrying

amounts at the beginning and end of the period_

o If indefinite: • Carrying amount of the asset. • Why it is considered to have an

indefinite life. • Restrictions on title. • Pledges as security_ • Contractual agreement to purchase any

intangible assets. • If the revaluation model is used, the

company must disclose: o The date of revaluation. o Details of fair value determination. o The carrying amount under the cost

modeL o Amount of revaluation surplus_

Disclosures: Impairment

IFRS

• The amounts of impairment losses and reversal of impairment losses recognized in the period.

• Where these impairment losses and reversals are recognized on the financial statements.

• Main classes of assets affected by impairment losses and reversals.

• Events and circumstances that led to these impairment losses and reversals.

U.S.GAAP

• Gross carrying amounts in total and by major classes of intangible assets_

• Accumulated amortization in total and by major classes of intangible assets_

• Aggregate amortization expense for the period_

• Estimated amortization expense for the next 5 fiscal years.

U.S.GAAP

• Description of the impaired asset. • Circumstances that led to impairment. • The method of fair value determination_ • The amount of impairment loss. • Where the loss is recognized on the

financial statements.

© 2017Wiley

Disclosures about long-lived assets appear throughout the financial statements:

The balance sheet reports the carrying value of the asset. On the income statement, depreciation expense may or may not appear as a separate line item_ Under IFRS, whether the income statement discloses depreciation expense separately depends on how the company groups its expenses.

o If the company groups expenses by nature, it aggregates them into categories like depreciation, purchases of materials, transport expenses, and advertising costs, and does not reallocate them among separate functions.

o If the company groups them by function, it classifies expenses according to the function, for example as part of COGS or SG&A.

On the cash flow statement: o Acquisitions and disposals of fixed assets are found in the investing section. o Further, if prepared using the indirect method, depreciation and

amortization are shown as separate line item adjustments to net income in the computation of cash flow from operating activities.

The notes to the financial statements describe the company's accounting methods, estimated useful lives, historical cost by categories of fixed asset, accumulated depreciation, and annual depreciation expense.

These disclosures help an analyst to understand a company's investments in tangible and intangible assets, how these investments changed during the reporting period, how the changes affected current performance, and what those changes might indicate regarding future performance.

When examining a company's fixed assets, analysts make use of the fixed asset turnover ratio and asset age ratios.

Fixed Asset Turnover Ratio

The fixed asset turnover ratio is calculated as total revenue divided by average net fixed assets. The higher this ratio, the higher the amount of sales a company is able to generate with a given amount of investment in fixed assets, suggesting that the company is operating more efficiently.

Asset Age Ratios

As you will see shortly, asset age ratios rely on the relationship between historical cost and depreciation. Under the revaluation model (permitted under IFRS but not U.S. GAAP), the relationships among carrying amount, accumulated depreciation, and depreciation expense will differ when the carrying amount differs significantly from the depreciated historical cost. Therefore, the discussion here applies primarily to PP&E reported under the cost model.

Recall that gross fixed assets (historical cost) minus accumulated depreciation equals net fixed assets (book value).

Gross fixed assets =Accumulated depreciation+ Net fixed assets

©2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

Below, we divide both sides of this equation by annual depreciation expense, and assume straight-line depreciation and zero salvage values for all fixed assets.

I Gross investment in fixed assets Accumulated depreciation Net investment in fixed assets = +

Annual depreciation expense Annual depreciation expense Annual depreciation expense

l l i Estimated useful or depreciable Average age of asset Remaining useful life

life Annual depreciation expense The book value of the

The historical cost of an asset times the number of years that asset divided by annual

divided by its useful life equals the asset has been in use equals depreciation expense equals

annual depreciation expense under accumulated depreciation. the number of years the asset

the straight-line method_ Therefore, Therefore, accumulated has remaining in its useful

the historical cost divided by depreciation divided by annual life_

annual depreciation expense equals depreciation equals the average the estimated useful life_ age of the asset.

The older its assets and the shorter their remaining useful lives, the more a company may need to reinvest to maintain productive capacity.

The calculations of estimated useful life, average age, and remaining useful life are important because:

They help identify older, obsolete assets that might make the firm 's operations less efficient. They help forecast future cash flows from investing activities and identify major capital expenditures that the company might need to raise cash for in the future_

In reality, these estimates are difficult to make with great accuracy_ Fixed asset disclosures are often quite general, with assets that have different salvage values, depreciation methods, and useful lives often grouped together. However, asset age ratios are helpful in identifying areas that require further investigation. See Example 3-2.

Example 3-2: Analysis of Fixed Asset Disclosures

Harton Inc_ and Bense! Inc_ operate in the same industry_ An analyst gathers the following information from their fixed asset disclosures:

Harton (2007) Gross fixed assets = $500,000 Accumulated depreciation = $200,000 Depreciation expense= $100,000

Benset (2007) Gross fixed assets= $750,000 Accumulated depreciation = $600,000 Depreciation expense= $150,000

Calculate the average age, average depreciable life, and remaining useful life of the companies' fixed assets. What conclusions can be drawn from these estimates?

© 2017Wiley

Solution:

Average age Average depreciable life Remaining useful life

Harton 200,000/100,000; 2 years 500,000/100,000; 5 years 300,000/100,000; 3 years

Benset 600,000/150,000; 4 years 750,000/150,000; 5 years 150,000/150,000; 1 year

The age estimates calculated above suggest that Benset's assets are, on average, older than Barton's_ We can forecast that Benset will need to raise cash fairly soon to invest in newer fixed assets. Since both the companies operate in the same industry and use the same depreciation method, we would expect the average depreciable lives of their assets to be similar_

If the calculated average depreciable life of a company's assets is in line with those of other firms in the industry that use similar equipment, we can conclude that management is not tweaking useful life and salvage value assumptions to manipulate reported profits_

Another popular method for making comparisons across companies is through the ratio of annual capital expenditure to depreciation expense_ A company for which this ratio is significantly lower than 100% is currently replacing its fixed assets at a rate that is slower than the rate at which they are being depreciated. This might suggest the need for hefty capital expenditure in the future and indicate that further examination of the company's capital expenditure policies is required. A company for which this ratio is close to 100% is replacing its fixed assets at a rate similar to that of their use_

Ideally, estimates of the average useful life of a company's assets should exclude land, which is not depreciated, if asset-specific information is available_

Bear in mind that the following differences can affect comparisons across companies:

Differences in the composition of the companies' operations and differences in acquisition and divesture activity. Use of different accounting standards_ Use of different depreciation methods_ Differences in the grouping of assets in fixed asset disclosures_

LOS 29n: Compare the financial reporting of investment property with that of property, plant, and equipment. Vol 3, pp 510-513

Investment Property

IFRS defines investment property as property that is owned (or leased under a finance lease) for the purpose of earning rentals or capital appreciation or both. 1

Investment property differs from long-lived tangible assets (e_g., PP&E) in that investment property is not owner occupied, nor is it used for producing the company's products and services. Long-lived tangible assets that are held for sale in a company's normal course of business (e.g., houses made by a construction company) are also not classified as investment property_ These assets would be included in the company's inventory.

I - lAS 40 Investment Property prescribes the accounting treatment for investment property.

© 2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

Note that valuation gains/losses on investment properties are different from gains/ losses on disposaJ ofinveslment property. Valuation gains/losses are related to changes in fair values of properties(those that are accounted for using the fair value model) that are still held by the company at the end of the year.Gains! losses on disposaJ of investment property relate to properties that have been disposed of (sold or exchanged) by the company during the year at a price different from their carrying amount.

Under IFRS, investment property may be valued using the cost model or fair value model.

Cost model: This is identical to the cost model used for property, plant, and equipment. Fair value model: This differs from the revaluation model used for PP&E in the way net income is affected.

o Under the revaluation model, the impact of the revaluation on net income depends on a previously recognized increase or decrease in the carrying amount of the asset.

o Under the fair value model, all changes in the fair value of an asset impact net income.

A company is required to use one model (cost or fair value) for all of its investment properties. Further, the fair value model may be used only if the company is able to reliably estimate the property 's fair value on a continuing basis.

If a company chooses the fair value model, it must continue to do so until it disposes of property or changes its use such that it is no longer classified as investment property. The fair value model must be applied consistently even if it becomes difficult to estimate fair value (e.g., due to infrequent comparable-property transactions).

The following valuation issues arise when the classification of investment property changes to or from owner-occupied property or inventory:

If investment property is valued using the cost model, a move to owner-occupied property or inventory will not lead to a change in the carrying amount of the property. If investment property is valued using the fair value model, a move to owneroccupied property or inventory will be made at fair value. The property's fair value will become its new cost for the purpose of ongoing accounting for the property. If owner-occupied property is reclassified as investment property (and the owner prefers to use the fair value model), the change in the value from depreciated cost to fair value at the time of transfer is treated like a revaluation. If inventory is reclassified as investment property (and the owner prefers to use the fair value model), the difference between the carrying amount and fair value at the time of transfer is recognized as a profit or loss.

Investment property is reported as a separate line item on the balance sheet. Further, companies must disclose which model they have used (cost or fair value) to value the property.

If the company uses the fair value model, it must make additional disclosures regarding how it has detennined fair value and reconcile beginning and ending carrying amounts of investment property. If the company uses the cost model, it must make additional disclosures sintilar to those required for PP&E (e.g., the depreciation method used and useful life). Further, the fair value of the property should also be disclosed.

U.S. GAAP does not specifically define investment property. It does not distinguish between investment property and other types of long-lived assets. U.S. companies that hold investment-type property use the historical cost model.

©2017Wiley

LESSON 4: LEASING

LOS 290: Explain and evaluate how leasing rather than purchasing assets affects financial statements and ratios. Vol 3, pp 513--530

LOS 29p: Explain and evaluate how finance leases and operating leases affect financial statements and ratios from the perspective of both the lessor and the lessee. Vol 3, pp 513--530

Leasing

A lease is a contract between the owner of the asset (lessor) and another party that wants to use the asset (lessee)_ The lessee gains the right to use the asset for a period of time in return for periodic lease payments. Leasing an asset holds the following advantages over purchasing the asset:

Leases often have fixed interest rates, and can provide less costly financing. They require little or no down payment so they conserve cash_ At the end of the lease, the asset can be returned to the lessor so the lessee escapes the risk of obsolescence and is not burdened with having to find a buyer for the asset. The lessor may be in a better position to value and dispose of the asset Negotiated lease contracts usually have fewer restrictions than borrowing contracts. The lessor can take advantage of the tax benefits of ownership such as depreciation and interest. In the United States, leases can be structured as synthetic leases, where the company can gain tax benefits of ownership, and at the same time avoid recognition of the asset on its financial statements.

Lessee's Perspective

U.S. GAAP requires a lessee to classify a lease as a capital lease if any of the following conditions hold:

1. The lease transfers ownership of the asset to the lessee at the end of the term_ 2. A bargain purchase option exists. 3. The lease term is greater than 75% of the asset's useful economic life_ 4. The present value of the lease payments at inception exceeds 90% of the fair value

of the leased asset

If none of these conditions hold, the lessee may treat the lease as an operating lease.

Under IFRS, classification of a lease depends on whether all the risks and rewards of ownership are transferred to the lessee. If they are, the lease is classified as a finance lease; and if they are not, the lease is classified as an operating lease_

Operating Lease (Lessee's Perspective)

The accounting treatment for an operating lease is similar to that of simply renting an asset for a period of time_ The asset is not purchased; instead, payments are made for using it

©2017Wiley

LONG-LIVED ASSETS

Finance lease is IFRS tenninology and capital lease isU.S.GAAP tenninology.

Note that recently proJXlsed accounting standards would eliminate these criteria.

LONG-LIVED ASSETS

Under an operating lease, no lease-related entries are made on the balance sheet The firm has effectively rented a piece of equipment_ It has not purchased the asset, so there is no addition to fixed assets, and it has not borrowed any money to finance the purchase, so there are no related liabilities_

Accounting Entries at Inception

Balance sheet: None, because no asset or liability is recognized. Income statement: None, because the asset has not been used yet. Cash flow statement: None, because there has been no cash transaction_

Accounting Entries Every Year during the Term of the Lease

Balance sheet: None, because no lease-related assets and liabilities are recognized. Income statement: Leasehold (rental) expense is charged every year. Cash flow statement: The lease payment is classified as a cash outflow from operating activities.

Capital or Finance Lease (Lessee's Perspective)

A finance lease requires the company to recognize a lease-related asset and liability on its balance sheet at inception of the lease_ The accounting treatment for a finance lease is similar to that of purchasing an asset and financing the purchase with a long-term loan_


Balance sheet: The present value of lease payments is recognized as a long-lived asset_ The same amount is also recognized as a noncurrent liability. Income statement: None because the asset has not been used yet. Cash flow statement: None because no cash transaction has occurred_ Disclosure of lease inception is required as a "significant noncash financing and investing activity."

Accounting Entries Every Year during the Term of the Lease

Balance sheet: The value of the asset falls every year as it is depreciated. Interest is charged on the liability as the appropriate discount rate times the beginning-of-year value of the liability_ The excess of the lease payment over the year's interest expense reduces the liability. Income statement: Depreciation expense (against the asset) and interest expense (on the liability) are charged every year. Cash flow statement: The portion of the lease payment equal to the interest expense is subtracted from CFO, while the remainder that serves to reduce the liability is subtracted from CFE See Example 4- L

© 2017Wiley

Example 4-1: Lease Classification by Lessees

ABC Company leases an asset for 4 years, making annual payments of$ I 0,000_ The appropriate discount rate is 7%_ Illustrate the effects on the financial statements if the lease is classified as a finance lease and as an operating lease_

Solution:

First let us work through the effects on the financial statements of the lessee if the lease is classified as a finance lease.

The present value of the lease payments is recognized as an asset and a liability. The PY of the lease payments equals $33,872 (PMT = $!0,000; N = 4; J/Y = 7; CPT PY).

The following table illustrates the calculation of periodic interest expense and the ending value of the liability for a finance lease:

Year

1

2

4

Discount rate times the value of the liability at the beginning of the period.

Present value of lease paymenrs.

For Year 1: 7% x $3 3,872

Beginning Liability

~

$

33,872

26,243

18,080

9 ,346

Interest

--

$

2,371

1,837

1,266

654

Lease payment minus interest component.

For Year I: $ 10,000 - $2,37 1

Beginning liability minus principal repayment. The excess of the lease payment over interest expense serves

to retire a portion of the liability every year.

For Year I: $33,872 - $7,629

Principal Closing Repayment

--$

7,629

8,163

8,734

9,346

Liability

-

$

26,243

18,080

9,346

0

There are two ways to calculate the ending value of the liability for any period:

1. Opening liability minus the excess of the lease payment over the period's interest expense.

For Year 1: $33,872-($I0,000-$2,371) = $26,243

2. Present value of remaining lease payments.

For Year 1: N = 3, J/Y = 7, PMT = $10,000, CPT PY; PY= $26,243

In an operating lease, no lease-related asset or liability is recognized on the balance sheet of the lessee. The lease payments are classified as operating expenses on the income statement.

©2017Wiley

LONG-LIVED ASSETS

LONG-LIVED ASSETS

Assets Leased assets

Now let us compare the effects on the lessee's financial statements of classifying a lease as an operating or finance lease:

Balance Sheet

Value of asset recognized at inception; $33,872 (Present value of lease payments) Annual depreciation (Straight-line); $8,468. See Table 4-1.

YearO $

33,872

Year 1 $

33,872

Year2 $

33,872

Year3 $

33,872

Year4 $

Portion of liability that will be retired

Accumulated depreciation 0 8,468 16,936 25,404

33,872

33,872 0

within 1 year is classified as a

Net leased assets 33,872 25,404 16,936 8,468 current liability.

Liabilities Current portion of lease obligation 7,629 8,163 8,734 9,346

o_J LT debt: Lease obligation 26,243 18,080 9,346 0 Total liabilities

@)

33,872 26,243 18,080 9,346

Portion of liability that will be retired in more than a year's time is classified as a long-term liability.

Table 4-1: Balance Sheet Effects of Lease Classification

Balance Sheet Item Finance Lease Operating Lease

Assets Higher Lower

Current liabilities Higher Lower Long-term liabilities Higher Lower Total cash Sarne Sarne

Income Statement

In an operating lease, the annual lease payment is recognized as an operating expense, while in a finance lease, the asset is depreciated and interest expense is charged against operating income (EBIT). See Table 4-2.

Finance Lease Operating Lease Depreciation Interest Total

Expense Expense Expense Rent Expense Total Expense Year $ $ $ $ $

1 8,468 2,371 10,839 10,000 10,000

2 8,468 1,837 10,305 10,000 10,000

8,468 1,266 9,734 10,000 10,000 4 8,468 654 9,122 10,000 10,000

TOTAL 33,872 6,128 40,000 40,000 40,000

© 2017Wiley

Table 4-2: Income Statement Effects of Lease Classification

Income Statement Item

Operating expenses

Nonoperating expenses

EBIT (operating income)

Total expenses-early years

Total expenses- later years

Net income-early years

Net income- later years

Statement of Cash Flows

Finance Lease

Lower (Depreciation)

Higher (Interest expense)

Higher

Higher

Lower Lower Higher

Operating Lease

Higher (Lease payment)

Lower (None)

Lower

Lower Higher

Higher

Lower

Under an operating lease, the lease payments are deducted from CFO, while for a finance lease the interest expense portion of the lease payment is deducted from CFO, and the remainder that serves to decrease the value of the liability is deducted from CFE See Table4-3.

Finance Lease Operating Lease

Year CFO$ CFF$ Total$ CFO$

1 -2,371 -7,629 -10,000 -10,000

2 -1 ,837 -8,163 -10,000 -10,000

-1 ,266 -8,734 -10,000 -10,000

4 -654 -9,346 -10,000 -10,000

Table 4-3: Cash Flow Effects of Lease Classification

CF Item

CFO

CFF

Total cash flow

©2017Wiley

Finance Lease

Higher

Lower

Same

Operating Lease

Lower

Higher

Same

LONG-LIVED ASSETS

LONG-LIVED ASSETS

Note: Lower ROE under a finance lease is due to lower net income (numerator effect), while lower ROA is primarily due to higher assets (denominator effect).

Table 4-4: Impact of Lease Classification on Financial Ratios

Numerator Denominator Ratio Better or under under Finance Worse under

Ratio Finance Lease Lease Effect on Ratio Finance Lease

Asset turnover Sales-same Assets-higher Lower Worse

Return on assets* Net income- Assets-higher Lower Worse lower

Current ratio Current Current Lower Worse assets-same liabilities-

higher

Leverage ratios Debt-higher Equity-same Higher Worse (DIE and DI A**) Assets-higher

Return on equity* Net income-- Equity-same Lower Worse lower

* ln early years of the lease agreement. **Notice that both the numerator and the denominator for the DIA ratio are higher when classifying the lease as a finance lease. Beware of such exam questions. When the numerator and the denominator of any ratio are heading in the same direction (either increasing or decreasing), determine which of the two is changing more in percentage terms. If the percentage change in the numerator is greater than the percentage change in the denominator, the numerator effect will dominate.

Firms usually have lower levels of total debt compared to total assets. The increase in both debt and assets by classifying the lease as a finance lease will lead to an increase in the debt-to-asset ratio because the percentage increase in the numerator is greater.

Disclosures

Under U.S. GAAP, given the explicit standards required to classify a lease as a capital lease, companies can easily structure the terms of a lease in a manner that allows them to report it as an operating lease (it must simply ensure that none of the four capital leaseclassifying criteria are met in the terms of the lease).

Lease disclosures require a company to disclose its lease obligations for each of the next 5 years under all operating and finance leases_ Further, lease obligations for all subsequent years must be aggregated and disclosed. These disclosures allow analysts to evaluate the extent of off-balance-sheet financing used by the company_ They can also be used to determine the effects on the financial statements if all the operating leases were capitalized and brought "on to" the balance sheet. See Example 4-2_

Under IFRS, companies are required to:

Present finance lease obligations as a part of debt on the balance sheet. Disclose the amount of total debt attributable to obligations under finance leases. Present information about all lease obligations (operating and finance leases). Future payments for the first year must be disclosed, aggregated for years 2 through 5, and aggregated for all subsequent years.

©2017Wiley

LONG-LIVED ASSETS

Example 4-2: Analysis of Lease Disclosures

ABC Company has significant commitments under finance and operating leases_ Presented here is selected financial statement information:

Finance Operating Year $ $ 2009 1,500 4,500

2010 1,500 4,000

2011 1,500 4,250

2012 1,500 5,000

2013 1,500 5,250

2014 1,850 4,750

2015 1,850 4,800

2016 1,850 4,800

2017 2,000 3,500

2018 2,000 3,200

Minimum future lease payments 17,050 44,050

Less: Total interest amount 7,116-34

Present value of minimum lease payments 9,933_66

I. Calculate the implicit rate used to calculate present value of minimum lease payments.

2. Why is this implicit rate important in evaluating the company's leases? 3. If operating leases were to be classified as capital leases, what additional

amount would be recognized on the balance sheet under lease obligations? 4. What would be the effect on the debt-to-equity ratio of treating all leases as

finance leases?

Solution:

I. The rate implicit in the lease is the discount rate that equates the present value of future lease payments to the given present value ($9,933.66). It is equivalent to the IRR of the cash flow stream. In this example, the rate equals 10.5%.

2. The rate implicit in the lease is important because it is used to determine the present value of lease obligations (liability), the value of the leased asset on the balance sheet, interest expense, and the lease amortization schedule_ Companies may use higher implicit rates to report lower debt levels_ The validity of the rate used by the company can be evaluated by comparing it to the rates used by comparable firms and considering recent market conditions_

3. If the operating leases were treated as finance leases, the present value of lease payments would be recognized as an asset and a liability. The present value of operating lease obligations equals $26,798 (using the 10.5% implicit rate)_

4. Debt levels rise when operating leases are recognized on the balance sheet Therefore, the debt-to-equity ratio rises (worsens)_

© 2017Wiley

LONG-LIVED ASSETS

When the lease is classified as an operating lease, the asset is listed on the balance sheet of the lessor, who continues to depreciate it. No lease-related asset shows up on the lessee's balance sheet.

When the lease is classified as a finance/capital lease, the lessor removes the longlivedassetfromits balance sheet, and instead records a receivable in its books. The lessee records the longlived asset on its balance sheet and depreciates it.

IFRS does not make a distinction betweenasalestype lease and a direct-financing lease. However, a similar treatment to sales-type leases is allowed for finance leases originated by "manufacturers or dealer-lessors."

Lessor's Perspective

Under IFRS, the lessor must classify the lease as a finance lease if all the risks and rewards of ownership are transferred to the lessee.

Under U.S. GAAP, lessors are required to recognize capital leases when any one of the four previously mentioned criteria for recognition of a capital lease by the lessee hold, and the following two criteria also hold:

I. Collectability of the lease payments is predictable_ 2. There are no significant uncertainties regarding the amount of costs still to be

incurred by the lessor under the provisions of the lease agreement

Leases not meeting these criteria must be classified as operating leases because the earnings process is not complete.

If the lessor classifies the lease as an operating lease, it records lease revenue when earned, continues to list the asset on its balance sheet, and depreciates it every year on its income statement_ If the lessor classifies the lease as a finance lease, it records a receivable equal to the present value of lease payments on its balance sheet, and removes the asset from long-lived assets in its books_ See Example 4-3_

Capital Leases

Under U.S. GAAP, lessors can classify finance leases into two types:

1. Some manufacturers offer their customers financing options to purchase their products_ These sales-type leases result in a gross profit (the normal selling price of the product minus its cost), which is recognized at inception of the lease, and interest income as payments are received over the lease term. In a sales-type lease, the present value of lease payments equals the selling price of the asset

2. Financial institutions and leasing companies offer financial leases that generate interest income only. These are known as direct financing leases, where the present value of lease payments equals the carrying value of the asset Further, there is no gross profit recognition at lease inception.

© 2017Wiley

Example 4-3: Operating Lease versus Direct Financing Lease-Lessor's Perspective

A company leases out a piece of equipment for 4 years in return for a lease payment of $10,000 every year_ At the end of the lease term the asset will have no salvage value_ The discount rate applicable is 6% and the carrying value of the leased asset is $34,651. How will this lease be classified by the lessor? Illustrate the impact of the lease on the company's financial statements each year during the term of the lease.

Solution:

We must calculate the present value of lease payments to detennine whether the lease should be classified as a sales-type lease or a direct financing lease. The present value of lease payments equals $34,651 (PMT = $10,000; l/Y = 6; N = 4; FY = O; CPT PY), which equals the carrying value of the asset on the lessor's books. Therefore, this is a direct financing lease.

At inception, the lessor removes the carrying value of the equipment from long-lived assets in its books (derecognizes the asset). Instead, the lessor recognizes a lease receivable asset equal to the present value of lease payments.

Lease Amortization Schedule

The present value

of the lease payments receivable over the term of the lease.

The discount rate multiplied by the opening balance of lease receivable account.

For Year I: 6% x $34,65 1

Opening Lease Interest

The excess of the annual lease payment over interest income.

For Year I: l0.000 - 2,079

Reduction in Lease Lease

Year Receivable Income Payment Receivable $ $ $ $

1 ~34,651 ~2,079 10,000 ~7,921

2 26,730 1,604 10,000 8,396 - 3 18,334 1,100 10,000 8,900

4 9,434 566 10,000 9,434 TOTAL 5,349 40,000 34,651

Opening lease receivable adjusted for the reduction in lease receivable over the year.

For Year 1: 34,651 - 7,921

I Closing Lease

Receivabh $

26,730-

18,334 9,434

0

For Year 3, the lessee owed the company interest of $1, I 00. However, the total payment made by the lessee in Year 3 I was $10,000. The excess ($10,000 - $1,100) reduced the total receivable amount.

©2017Wiley

LONG-LIVED ASSETS

I This asset is reported on the balance sheet.

LONG-LIVED ASSETS

Effects on Income Statement

Depreciable value = $34,651 Life of asset = 4 years Annual depreciation= $8,662_75

Direct Financing Lease

Year Income

I Interest income ~2,079

2 Interest income ~1 ,604

Interest income 1,100 4 Interest income 566

TOTAL 5,349

Revenue

10,000 10,000

10,000 10,000

In an operating lease, the lessor realizes rental income every year, and charges depreciation expense on the asset leased out

t Operating Lease

Depreciation

8,662-75 8,662_75

8,662_75

8,662-75

Income

1,337-25 1,337_25

l,337-25 i 1,337-25

5,349

In the early years, higher income is recognized under a direct fin ancing lease. This results in more taxes being paid out sooner.

Total income over the Higher income is recognized in later years tenn of the lease is the under an operating lease. Payment of taxes same across both is therefore delayed for a period. classifications.

Effects on Cash Flow Statement

Direct Financing Lease Operating Lease

Year - CFO CFI - Total CFO

I 2,079 7,921 10,000 10,000

2 1,604 8,396 10,000 10,000 1,100 8,900 10,000 10,000

4 566 9,434 10,000 10,000

TOTAL 5,349 34,651 40,000 40,000

Interest income is a cash Reduction in lease I receivable asset is a cash

inflow from operations. inflow from investing activities.

Table 4-5: Financial Statement Effects of Lease Classification from Lessor's Perspective

Financing Lease Operating Lease

Total net income Same Same

Net income (early years) Higher Lower

Taxes (early years) Higher Lower

Total CFO Lower Higher

Total CF! Higher Lower

Total cash flow Same Same

Total cash flow over the lease tenn is the same under both classifications. Notice, however, that CFO is higher under an operating lease whileCFI is higher under a financing lease.

© 2017Wiley

Sales-Type Leases

In a sales-type lease, the present value of lease payments is greater than the carrying value of the asset in the lessor's books. Consequently, the lessor recognizes a gross profit equal to the difference between the two in the year of inception, and recognizes interest income over the term of the lease_ See Example 4-4_

Example 4-4: Sales-Type Leases

A company leases out a piece of equipment for 4 years in return for a lease payment of $10,000 every year_ At the end of the lease term, the asset will have no salvage value_ The discount rate applicable is 6% and the carrying value of the asset is $30,000_ How will this lease by classified by the lessor? Illustrate the impact of the lease on the company's gross profits and construct the lease amortization schedule_

Solution:

Notice that we are working with similar numbers as in Example 4-3_ We have only changed the carrying value of the asset on the lessor's books to $30,000 in this example_

Since the present value of lease payments (which we have previously calculated as $34,651) is greater than the carrying value of the asset, this is a sales-type lease.

At inception, the lessor will recognize a gross profit of $4,651 (; $34,651 - $30,000)_

The lessor also recognizes interest income over the term of the lease. Notice that interest income is the same as we had calculated in the direct financing lease in Example 4-3. We only changed the carrying value of the asset in this example to illustrate that under a sales-type lease, in addition to interest income, the lessor also recognizes a gross profit on sale that increases total income over the lease, and results in a significant contribution to profits at inception_ For Year 1, the lessor recognizes gross profit on sale of $4,651 and interest income of $2,079_


Opening Reduction Closing Lease Interest Lease in Lease Lease

Year Receivable Income Payment Receivable Receivable

1 34,651 2,079 10,000 7,921 26,730

2 26,730 1,604 10,000 8,396 18,334

18,334 1,100 10,000 8,900 9,434

4 9,434 566 10,000 9,434 0

TOTAL 5,349 40,000 34,651

© 2017Wiley

LONG-LIVED ASSETS

READING 30: INCOME TAXES

LESSON 1: KEY DEFINITIONS AND CALCULATING THE TAX BASE OF ASSETS AND LIABILITIES

LOS 30a: Describe the differences between accounting profit and taxable income and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense. Vol 3, pp 550--551

The tax return is prepared to calculate taxes payable to the authorities. Taxes payable result in an outflow of cash from the firm, so firms try to minimize taxes payable and retain cash. This objective is achieved by recognizing higher expenses on the tax return, which leads to lower taxable income and consequently lower taxes payable.

Financial statements are prepared to report the company's operating performance over the year to shareholders, financial institutions, and other stakeholders. For financial reporting purposes, companies try to show healthy performance and profitability. This objective is achieved by recognizing lower expenses on the income statement, which lead to higher pretax income, and (despite higher income tax expense) higher net income than on the tax return.

In Exhibit 1-1, we illustrate the differences between the tax return and the financial statements of ABC Company for 2009. ABC makes sales worth $100, incurs cost of goods sold of $60, and recognizes other gains of $10. On the tax return, it recognizes depreciation of $40 for the year, while on the income statement it recognizes depreciation of $30 only. Depreciation is the only expense incurred by ABC in 2009. The company pays taxes at the rate of 40%.

Exhibit 1-1

ABC Company Tax Return Calculation of Taxes Payable for 2009

The before-tax figure on the tax

return is known as taxable income.

Sales Less: Cost of goods sold Gross profit

' Less: Depreciation expense ~ Add:Gains

~----~ Taxable income The actual amount of tax payable is ...------ Taxes payable known as taxes Profit after tax payable.

©2017Wiley

$ 100 Higher expense (60)/ shownontaxretum.

40 ( 40) Lower income

_!Q / subjccttotaxes.

IO Lower taxes payable helps cash flows.

(continued)

INCOME TAXES

We have reorganized the order of the LOS in this reading to make the concepts flow in a more structured

INCOME TAXES

Exhibit 1-1 (continuetl)

ABC Company Income Statement Calculation of Income Tax Expense for 2009

Sales The before-tax figure on the income statement is known as acmunting profit or pntax income.

Less: Cost of goods sold Gross profit

\. Less: Depreciation expense - Th- ,- wn- ou_n_t o_f_tax_ "" Add: Gains ::tu~ep:~mpany Accounting profit according to its Income tax expense financial statements / Profit after tax is known as income / tax expense.

$ I Lower expense on I 100 I financial statement.

(60) 40

(30) I Higher income I ~~ / subject totaxes.

____@_ I Higher profits after tax I 12 ______. please shareholders.

Depreciation expense is the source of discrepancy between taxable income and pretax income in Exhibit 1-1. This difference in the amount of depreciation recognized on the two sets of statements for 2009 also drives a difference in the tax base of the asset and the carrying value on the balance sheet (financial statements).

Assuming that 2009 is the year of fixed asset purchase, accumulated depreciation consists only of depreciation for 2009. There is no accumulated depreciation on the asset from previous years. Exhibit 1-2 illustrates the computation of the asset 's tax base and carrying value, assuming that the asset was purchased for $100.

Exhibit 1-2

Tax Base

$ Equipment 100

Accumulated depreciation for tax purposes ( 40)

Tax base of equipment 60

Financial Statements

Balance Sheet Extract

Noncurrent Assets

Equipment

Accumulated depreciation

Carrying value of equipment

$ 100

(30)

70

© 2017Wiley

From Exhibit 1-2, notice that:

The gross amount of equipment recognized on the two statements is the same ($100). Higher accumulated depreciation is subtracted from gross equipment on the tax return because higher depreciation was charged on the asset for tax purposes ($40) compared to financial reporting purposes ($30). Therefore, the tax base of the asset is lower ($60) than its carrying value ($70).

LOS 30c: Calculate the tax base of a company's assets and liabilities. Vol 3, pp 556-559

The tax base of an asset or liability is the amount at which the asset or liability is valued for tax purposes, while the carrying value is the amount recognized on the balance sheet for financial reporting purposes.

Determining the Tax Base of an Asset

An asset 's tax base is the amount that will be expensed on the tax return in the future as economic benefits are realized from the asset. For example, if the historical cost of an asset is $10,000, and $4,000 accumulated depreciation has already been charged against it on tax returns over previous years, the asset's tax base currently equals $6,000. The tax base is the amount that will be depreciated in future periods (expensed on the tax return) as the asset is utilized over its remaining life (economic benefits of the asset are realized).

The carrying value of an asset is simply the historical cost of the asset minus the accumulated depreciation charged against it in previous years on the company's financial statements.

Example 1-1: Determining the Tax Base of an Asset

Calculate the tax base and the carrying amount for the following assets:

1. A company has dividends of $1 million receivable from another company. Assume that dividends are not taxable.

2. A company capitalized $2 million in development costs. It amortized $500,000 over the year, but for tax purposes amortization of 30% is allowed each year.

3. A company incurred $1 million in research costs. All of these were expensed for financial reporting, but for tax purposes these costs must be written off over five years.

4. A company shows $200,000 as a provision for bad debts. The balance sheet amount for accounts receivable after providing for the doubtful debts is $2 million. Tax authorities allow a maximum of 30% of the gross amount of accounts receivable to be provided for doubtful debts for a given period.

©2017Wiley

INCOMETAXES

INCOME TAXES

Pay very careful attention to the wording here. The best way to deal with these problems is to commit the exact wording of the twofonnulas/rules to memory and then detennine whether the question concerns an accrued expense liability or an unearned revenue liability.

Solution

I. Dividends receivable are an asset of the company. Assets that are not taxable have a tax base that equals their carrying value. Therefore, the carrying amount and the tax base of the dividends receivable asset equal $1 million.

2. The company amortized $500,000 of development costs for financial reporting purposes, so the asset's carrying value is $1.5 million ($2 million - 500,000). Tax authorities allow 30% amortization per year, so on the tax return, $600,000 (30% of $2 million) will be amortized and the tax base will equal $1.4 million ($2 million - 600,000).

3. The company expensed the entire amount of the research costs on its financial statements, so no asset is recognized (carrying value equals zero). On the tax return, the company must write these costs off over 5 years, so the amount expensed on the tax return for the year will be $200,000 and the asset 's tax base will equal $800,000 ($1 million - 200,000).

4. The company has expensed $200,000 and shown the carrying value of accounts receivable as $2 million after deducting the expensed amount. On the tax return, the company can expense $660,000 (30% of $2.2 million). Therefore, the tax base of accounts receivable will equal $1.54 million ($2.2 million - 660,000).

Carrying Amount Tax Base

($) ($)

Dividends receivable 1,000,000 1,000,000

Development costs 1,500,000 1,400,000

Research costs 0 800,000

Accounts receivable 2,000,000 1,540,000

Determining the Tax Base of a Liability

Two types of liabilities can result from accrual accounting- unearned revenues and accrued expenses. The carrying value of these liabilities is the amount recognized on the balance sheet in the financial statements. The rules for calculating the tax base of these liabilities are as follows.

I . Tax base of accrued expense liability ; Carrying amount of the liability (financial reporting) minus amounts that have not been expensed for tax purposes yet, but can be expensed (are tax deductible) in the future.

2. The tax base of unearned revenue liability ; Carrying value of the liability minus the amount of revenue that has already been taxed, and therefore will not be taxed in the future.

Basically, the tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect to that liability in future periods. For revenue received in advance, the tax base of the resulting liability is its carrying amount, less any amount of that revenue that will not be taxable in future periods.

© 2017Wiley

Example 1-2: Determining the Tax Base of a Liability

Calculate the tax base and the carrying amount of the following liabilities:

1. During the year, a company made a donation of $1 million that it expensed for financial reporting purposes. Donations are not tax deductible.

2. The company received interest in advance of $500,000. Tax authorities recognize interest received as income on the date of receipt and consider it taxable.

3. The company recognized rent received in advance of $1 million. Rent received in advance is deferred for accounting purposes, but taxed when cash is received.

4. The company has to pay interest of $500,000 on its long-term loan of $8 million. The interest is payable at the end of each fiscal year.

5. The company estimates that $200,000 of warranty expenses will be incurred on manufactured units sold. However, for tax purposes no deductions are allowed for warranty expense until they are actually incurred. The company does not receive any warranty claims during the period.

Solution

1. The company expensed the entire amount of the donation so the carrying value of the liability equals zero. This liability is related to expenses so we use the first of the rules that we stated earlier to determine its tax base. The donation has not been deducted for tax purposes yet, but it is also not deductible in the future. Therefore, the amount that must be subtracted from the carrying value to determine its tax base equals zero.

Tax base of the liability = Carrying value - Amount tax deductible in the future

= 0 - 0 = 0

2. The carrying value of the liability related to interest received in advance is $500,000. This liability is related to unearned revenue, so we use the second rule to determine its tax base. For tax purposes, the entire amount of $500,000 has already been taxed in the current year as cash has been received. Consequently, these revenues will not be taxed in the future, so they are subtracted from the carrying value to determine the tax base of the liability.

Tax base of unearned revenue liability = $500,000 - $500,000 = 0

3. The carrying value of the liability related to rent received in advance (unearned revenue) is $1 million. For tax purposes, this entire amount has already been taxed in the current year as cash has been received, and will not be taxed in the future.

Tax base of unearned revenue liability = $1 million - $! million= 0

© 2017Wiley

INCOME TAXES

The donation has not been deducted for tax purposes, and is never going to be deducted on the tax return. It has already been recognized on the financial statements.

This difference in the treatment of donations for tax and accounting purposes is a permanent difference that will not reverse in the future. We will discuss these differences in detail in LOS 30f.

INCOME TAXES

LEGEND In the followin g analysis: • Tax return items

are~ in color.

• Financial

:~-=~~s color.

• Deferred tax amounts are typed in color.

4. Taking a loan or repaying it has no tax or income statement implications. The total amount of the loan ($8 million) is a long-term liability. Interest paid ($500,000) is expensed on the income statement and on the tax return, so there is no liability relating to interest payments.

5. The actual warranty expense will be incurred when claims are made in subsequent years. Therefore, the company shows a carrying value of warranty liability of $200,000 on the financial statements. This liability is related to expenses so we use the first rule to determine its tax base. The amount of $200,000 has not been deducted from revenues for tax purposes yet, but will eventually be deducted when actual expenses are borne.

Tax base of the warranty liability= $200,000-$200,000 = 0

Carrying Amount Tax Base ($) ($)

Donations (Permanent difference) 0 0

Interest received in advance 500,000 0

Rent received in advance 1,000,000 0

Loan (capital) 8,000,000 8,000,000

Interest paid 0 0

Warranty liability 200,000 0

LESSON 2: CREATION OF DEFERRED TAX ASSETS AND LIABILITIES, RELATED CALCULATIONS, AND CHANGES IN DEFERRED TAXES

LOS 30b: Explain how deferred tax liabilities and assets are created and the factors that determine how a company's deferred tax liabilities and assets should be treated for the purposes of financial analysis. Vol 3, pp 552--555

LOS 30d: Calculate income tax expense, income taxes payable, deferred tax assets, and deferred tax liabilities, and calculate and interpret the adjustment to the financial statements related to a change in the income tax rate. Vol 3, pp 559- 560

Under U.S. GAAP, a company can use a different depreciation method on its financial statements from the one it uses on its tax return. Taldng advantage of this facility, firms try to record higher depreciation expense on their tax returns to minimize taxes payable, and recognize lower depreciation expense on their financial reports to maximize reported profits. Let's see how this works through a comprehensive example.

Bestwear Inc. has only one fixed asset, which generates revenues of $10,000 every year. The only expense that Bestwear incurs is depreciation on this asset, whose original cost was $12,000. The firm decides to completely write off this asset over four years for financial reporting, and over three years for tax reporting. The applicable tax rate is 40%.

Exhibit 2-1 illustrates the computation of taxes payable and income tax expense (!TE) for Bestwear Inc.

©2017Wi ley

Exhibit 2-1: Income Statements ofBestwear Inc

Tax Reporting

Yearl Year2 Year3 Year4 Total

$ $ $ $ $ Revenue 10,000 10,000 10,000 10,000 40,000

Dep. exp. (3 yrs. st. line) 140001 14 0001 14.oool CJjJ 12,000

Taxable income 6,000 6,000 6,000 10,000 28,000

Taxes payable 12.4001 12.4001 12.4001 f\ ,OOO I 11,200

(40% of taxable income)

Profit after tax 3,600 3,600 3,600 6,000 16,800

Financial Reporting

Yearl Year2 Year3 Year4 Total

$ $ $ $ $ Revenue 10,000 10,000 10,000 10,000 40,000

Dep. exp. (4 yrs. st. line) - - - - 12,000

Pretax income 7,000 7,000 7,000 7,000 28,000

Income tax expense - - - - 11,200

( 40% of pretax income)

Profit after tax 4,200 4,200 4,200 4,200 16,800

Notice the following important things from Exhibit 2-1 before moving ahead:

1. Total depreciation charged on the asset over its entire life is the same across both statements ($12,000).

2. Total taxes payable and income tax expense over the life of the asset are the same across both statements ($11,200).

3. Total profit after tax over the life of the asset is the same across both statements ($16,800).

Essentially, the differences across the two sets of statements lie in the distribution of total depreciation expense ($12,000) over the four years.

Depreciation expense on the tax return is higher in Years I through 3 by $1,000 each year ($4,000I- $- ), so a difference of $3,000 accumulates over these three years. This cumulative difference is entirely offset, or reversed in Year 4 when depreciation on the tax return is lower than depreciation on financial statements by $3,000 C[Q] - $~.

A difference in expense recognition across the two statements that reverses in this manner is known as a temporary difference.

©2017Wiley

INCOME TAXES

INCOME TAXES

The cumulative DTL amount shows up on the balance sheet under liabilities.

If expense recognition for tax purposes is relatively aggressive, itwillgiverisetoa DTL.

The company will: Payless taxes now. Pay more taxes in the future.

Exhibit 2-2 reproduces Bestwear's taxes payable and income tax expense for the four years (calculated in Exhibit 2-1).

Exhibit2-2

Yearl Year2 Year3 Year4 $ $ $ $

Taxes payable 124.00I 124.00I 124,00I 124.00

Income tax expense - - - -Increase in deferred tax liability (DTL) 400 400 400 -1,200

DTL cumulative 400 800 1,200 0

The key here is to recognize that although total taxes payable and total income tax expense are the same ($11,200), their distribution over the years is not identical. Think of taxes payable as taxes that a company pays to the authorities. Think of income tax expense as the taxes that the company should pay according to its financial statements. In Years I, 2, and 3 the company pays lower taxes on the tax return ($12 4001 per year) than what it should according to its financial statements($- per year). Because the company actually pays less tax than it should, it creates a deferred tax liability (DTL) in Year I, whose balance increases in Years 2 and 3 as the annual shortfall persists.

In Year 4, however, the company pays out more taxes (taxes payable of $!4 OOOD than it should according to its financial statements (ITE of$- ). It pays an excess tax of $1,200. This $1,200 serves to retire the liability that the company had accumulated over the first three years when it was paying less tax than it should have (paying 00 less every year resulting in a cumulative liability of $1,200 by the end of Year 3). Even though by the end of Year 4 the company has paid off its entire tax liability, it gained a cash flow advantage by deferring the payment of a portion of total yearly taxes to Year 4.

One way to calculate the value of the DTL balance sheet account is by adding the change in DTL over the period to the previous year's balance sheet value. An easier way is to simply use the following formula:

DTL (cumulative) = (Carrying value of asset -Tax base)xTax rate

© 2017Wiley

We illustrate the computation of the tax base and carrying value of the asset and the calculation of the DTL balance for Bestwear in Exhibit 2-3.

Exhibit2-3

Tax Return Balance Sheet Extract

Year 1 Year2 Year3 Year4 $ $ $ $

Equipment 12,000 12,000 12,000 12,000

Accumulated depreciation (4,000) (8,000) (12,000) (12,000)

Tax base 8,000 4,000 0 0

Financial Statements Balance Sheet Extract

Year 1 Year2 Year3 Year4 $ $ $ $

Equipment 12,000 12,000 12,000 12,000

Accumulated depreciation (3,000) (6,000) (9,000) (12,000)

Carrying value [2,000 6,000 3,000 0

Using the formula on the previous page, Bestwear's DTL balance for each year is calculated as:

Year I: ( 9,000 - [[ODO) x 40% = $400 Year 2: (6,000 - 4,000) x 40% = $800 Year 3: (3,000 - 0) x 40% = $1,200 Year 4: (0 - 0) x 40% = 0

Once the balance sheet DTL value has been calculated, the change in DTL over a given period can be calculated using the following formula:

Change in deferred tax liability = Closing DTL balance - Opening DTL balance

Bestwear's change in DTL over each of the four years can be calculated as:

Year I: 400 - 0= $400

Year 2: 800 - 400= $400 ?>• In Years 1-3 there is an increase in DTL. Year 3: 1,200 - 800 = $400 Year 4: 0- 1,200= -$ 1,200 -rn Year4, there is a decrease in DTL.

©2017Wiley

INCOMETAXES

INCOME TAXES

The relationship between taxes payable (TP), change in deferred tax liabilities (DTL), and income tax expense (ITE) is driven by the following formula:

I ITE = TP + Change in DTL I

Once the tax returns of the company are ready and the amount of taxes payable is known, a company can compute income tax expense for the year simply by using the formula above. Bestwear's income tax expense for each of the four years is calculated as:

ITE=TP+Change in DTL

Year 1: 2,400 + 400 = $2,800 Year 2: 2,400 + 400 = $2,800 Year 3: 2,400 + 400 = $2,800 Year 4: 10)00 + (-1,200) = $-

To summarize, a deferred tax liability usually arises when:

Higher expenses are charged on the tax return compared to the financial statements. Taxable income is lower than pretax or accounting profit. Taxes payable are lower than income tax expense. An asset's tax base is lower than its carrying value.

Note that deferred tax liabilities can also arise due to temporary differences resulting from revenues (or gains) being recognized on the income statement before they are included on the tax return.

Accounting Entries for an Increase in Deferred Tax Liabilities

An increase in deferred tax liabilities increases total liabilities on the balance sheet. The increase in deferred tax liabilities is added to taxes payable in the calculation of income tax expense, so it decreases net income, retained earnings, and owners' equity.

Deferred Tax Assets

Deferred tax assets (OTA) usually arise when a company's taxes payable exceed its income tax expense. The company pays more taxes based on its tax return than it should pay according to its financial statements. This is a sort of a prepaymen~ and therefore counts as an asset.

Clearvision Inc. is a distributor of television sets, and has revenues of $10,000 every year. It offers a two-year warranty on its TV screens, and assumes that it will receive warranty claims of 5% of sales over each of the two years for financial statement purposes. For tax purposes, the company can recognize warranty expenses only when claims are actually made. Clearvision receives no claims in Year 1, but receives claims worth $1,000 in Year 2. Clearvision is taxed 40% of its profits.

Exhibit 2-4 demonstrates the calculation of income tax expense and taxes payable for Clearvision for the two years.

© 2017Wiley

Exhibit 2-4

Clearvision Inc.

Tax Return

Revenue

Warranty expense (actual expenses incurred)

Taxable income

Taxes payable (40% of taxable income)

Profit after tax

Clearvision Inc.

Income Statement

Revenue

Warranty expense (5% of sales)

Pretax income

Income tax expense (40% of pretax income)

Profit after tax

Comparison of taxes payable and income tax expense:

Year 1

$ Taxes payable 14.ooo l

Income tax expense -Increase in DTA 200

DTA cumulative 200

Year 1 $

10,000

0

10,000

14,0001

6,000

Yearl

$ 10,000

500

9,500 -5,700

Year2

$ 136,oo l --200

0

Year2 $

10,000

1,000

9,000

136,0001

5,400

Year2

$ 10,000

500

9,500 -5,700

Total

7,600

7,600

0

In Year I , taxes payable ($4,000) exceed income tax expense($- , giving rise to a deferred tax asset. The company pays more taxes than it should according to its financial statements. In Year 2, this temporary difference of $200 is entirely offset or reversed.

The carrying value of warranty expense liability on the balance sheet after Year I equals $500. Warranty claims are expensed on the tax return only when they are received, and no claims are received in Year I. At the end of Year I , the total value of expenses that have not been recognized on the tax return yet, but will be recognized in the future (when claims are actually received) is $500. Therefore, the tax base of the liability equals zero ($500 - $500).

In Year 2, the carrying value and the tax base of the warranty-related liability equal zero.

©2017Wiley

INCOME TAXES

If expense recognition for accounting purposes is relatively aggressive, it will give rise to a OTA.

The company will: Pay more taxes now. Paylesstaxesinthe future.

Recall that the tax base of an expenserelated liability equals its carrying value minus amounts that have not been recognized on the tax return yet, but will be expensed on the tax return in the future.

INCOME TAXES

Deferred tax asset balances at a given balance sheet date can be calculated using the following formula:

(Canying value of liability-Tax base ofliability) x Tax rate

Therefore, the deferred tax asset balances for Clearvision can be calculated as:

Year 1: (500 - 0) x 40% ; $200 Year 2: (0 - 0) x 40% ; 0

There is an increase in deferred tax assets of $200 in Year 1. However, in Year 2, the temporary difference in warranty expense recognition that gave rise to the deferred tax asset reverses. This results in a reduction in OTA of $200 and leaves the cumulative OTA balance at zero.

The relationship between taxes payable, the change in deferred tax assets, and income tax expense is captured by the following formula:

IITE ; TP-Change in DTA I

Therefore, once the company has prepared its tax return and determined the amount of taxes payable, it can easily calculate income tax expense by subtracting any increase in OTA over the period from taxes payable. Clearvision's income tax expense for the two years can be calculated as:

Year 1: ~- $200 ; $Year 2: ~- (-$200) ; $-

To summarize, a deferred tax asset arises when:

Higher expenses are charged on the financial statements than on the tax return. Taxable income is higher than pretax or accounting profit. Taxes payable are greater than income tax expense. A liability 's tax base is lower than its canying value.

Note that a deferred tax asset may also result from a temporary difference arising due to revenues (or gains) being recognized on the tax return before being recognized on the income statement.

Accounting Entries for an Increase in Deferred Tax Assets

An increase in deferred tax assets increases total assets on the balance sheet. The increase in deferred tax assets is subtracted from taxes payable in the calculation of income tax expense, so it increases net income, retained earnings, and equity.

LOS 30e: Evaluate the impact of tax rate changes on a company's financial statements and ratios. Vol 3, pp 559-560

When income tax rates change, the balances of deferred tax assets and liabilities on the balance sheet must be adjusted for the new tax rates. When tax rates rise, the balances of both deferred tax assets and liabilities rise. When tax rates fall, the balances of both deferred tax assets and liabilities fall.

© 2017Wiley

Let's work with the financial numbers of Bestwear Inc. that we introduced earlier, and now assume that in Year 3, tax rates are brought down to 30%. The information in Exhibit 2-5 is reproduced from Exhibits 2-1 and 2-3 to facilitate our analysis.

Exhibit 2-5

Year 1 Year2 Year3 Year4

$ $ $ $ Tax base 8,000 4,000 0 0

Carrying value 9,000 6,000 3,000 0

DTL cumulative 400 800 1,200 0

Depreciation expense

Year3

Tax reporting ~ Financial reporting -

Deferred tax liability (BS value)= (Carrying value - Tax base) x New tax rate

Therefore, the DTL balance at the end of Year 3 = (3,000 - 0) x 30% = $900

Although the difference between the carrying amount and the tax base of the asset is the same as before ($3,000), the deferred tax liability is lower because this difference is now multiplied by a lower tax rate to determine the end-of-year DTL amount on the balance sheet.

Compared to the scenario where tax rates were 40%, Year 3 deferred tax liabilities fall by $300 ($1 ,200 - $900) when tax rates are lowered to 30%.

This reduction can be broken down into two components:

1. The temporary difference of $1,000 (Sf\,0001- $- )in additional depreciation on the tax return in Year 3 will now result in a tax shield of only $300 ($1 ,000 x 30%) as compared to $400 ($1,000 x 40%) earlier. This reduces DTL by $100.

2. The cumulative deferred tax liability at the end of Year 2 will now be valued at the new tax rate and reduce DTL by 25%. [(40% - 30%) / 40%] 25% of the Year 2 DTL balance ($800) equals $200.

Therefore DTL decreases by $100 + $200 = $300.

Income tax expense for Year 3 will be calculated using the following formula:

Income tax expense= Taxes payable+ Change in DTL - Change in OTA

Taxes payable equal taxable income multiplied by the new tax rate.

I TP =$6,000x30% =$1,800 I

©2017Wiley

INCOME TAXES

Step 1: Calculate the change in DTL in the year of change intaxratesusingthe new tax rate.

Step 2: Adjust the value of the cumulative DTL balance from previous years for the change in tax

Bestwear'staxable income in Year 3 was $6,000 (Exhibit 2-1)

Bestwear had no deferred tax assets.

INCOME TAXES

Changes in tax rates have an impact on deferred tax asset and liability values as well as income tax expense in the year of change. Therefore, it is important to bear in mind that proposed changes in tax laws can have a quantifiable effect on key financial ratios.

Therefore:

I ITE=$1,800+(-300)=$1,500 I Our analysis allows us to reach the following important conclusions:

If a company has a net DTL (excess ofDTL over OTA), a reduction in tax rates would reduce liabilities, reduce income tax expense, and increase equity. If the company has a net OTA (excess of OTA over DTL), a reduction in tax rates will reduce assets, increase income tax expense, and decrease equity. If a company has a net DTL, an increase in tax rates would increase liabilities, increase income tax expense, and reduce equity. If the company has a net DTA, an increase in tax rates will increase assets, decrease income tax expense, and increase equity.

LOS 30f: Distinguish between temporary and permanent differences in pre-tax accounting income and taxable income. Vol 3, pp 560-565

Temporary differences arise because of differences between the tax base and carrying amounts of assets and liabilities. Permanent differences, on the other hand, arise as a result of expense or income items that can be recognized on one statement (tax return or income statement), but not the other. They are differences in tax and financial reporting of revenues and expenses that will not reverse at any point in the future. Examples of the items that give rise to permanent differences include:

I. Revenue items that are not taxable. For example, government grants are tax exempted; thus they are not accounted for in the tax returns but are still included in the financial statements.

2. Expense items that are not tax deductible. For example, fines and penalties in many jurisdictions are not tax-allowable expenses, but are still written off in the financial statements.

3. Tax credits for some expenses that directly reduce taxes.

The important thing to remember is that permanent differences do not result in deferred taxes. They result in differences between effective and statutory tax rates and should be considered in the analysis of effective tax rates. A firm's reported effective tax rate is calculated as:

Effective tax rate = Income tax expense Pretax income

The comprehensive examples in this relating to Bestwear and Clearvision were illustrations of temporary differences between the recognition of expenses on the tax return and on the income statement. Temporary differences can be divided into two categories:

1. Taxable Temporary Differences Taxable temporary differences result in deferred tax liabilities. They are expected to result in future taxable income. Deferred tax liabilities arise when:

The carrying amount of an asset exceeds its tax base; or The carrying amount of a liability is less than its tax base.

© 2017Wiley

Bestwear offered an example of taxable temporary differences. In Years 1 through 3, the carrying amount of the asset exceeded its tax base and resulted in a deferred tax liability.

2. Deductible Temporary Differences Deductible temporary differences result in deferred ta.x assets. They are expected to provide tax deductions in the future. Deferred tax assets arise when:

The tax base of an asset exceeds its carrying amount; or The tax base of a liability is less than its carrying amount.

Clearvision offered an example of deductible temporary differences. In Year 1, the carrying value of the warranty liability exceeded its tax base and resulted in a deferred tax asset.

Bear in mind that the recognition of a deferred tax asset is allowed only when there is a reasonable expectation of future profits against which these assets can provide tax deductions.

As long as the difference is temporary, the rules in Table 2-1 will help you ascertain the nature of the deferred tax items created.

Table 2-1

Balance Sheet Item Carrying Value vs. Tax Base Results in ...

INCOMETAXES

Asset Asset

Liability Liability

Carrying amount is greater. Tax base is greater.

DTL----... 1 Bestwear example I

OTA Carrying amount is greater. OTA----• I Clearvision example I

Tax base is greater. DTL

For each of the entries listed in Table 2-2, indicate whether the difference between the tax base and the carrying amount of the asset or liability is temporary or permanent and whether a deferred tax asset or liability will be created. The related transactions were discussed earlier when we calculated the tax bases of assets and liabilities under LOS 30c.

Table 2-2

I.

2.

3.

4.

5.

6.

7.

8.

9.

Carrying Value Tax Base

Dividends receivable 1,000,000 1,000,000

Development costs 1,500,000 1,400,000

Research costs 0 800,000

Accounts receivable 2,000,000 1,540,000

Donations 0 0

Interest received in advance 500,000 0

Rent received in advance 1,000,000 0

Loan (capital) 8,000,000 8,000,000

Interest paid 0 0

Warranty expense 200,000 0

1. We stated earlier that dividends receivable were not taxable. The related income will never be included on the tax return to calculate taxable income. The difference in income recognition between the tax return and the financial statements will never reverse, so taxable income and accounting profit will permanently differ.

©2017Wiley

INCOME TAXES

2. The carrying value of capitalized development costs (asset) exceeds the tax base. This is a temporary difference, so a deferred tax liability will be created (see Table 2-1). Taxable income will be higher in future years when reversal occurs.

3. The carrying value of capitalized research costs is lower than their tax base. This is a temporary difference, so a deferred tax asset will be created. Taxable income will be lower in the future as these costs are written off for tax purposes.

4. The difference between the carrying amount and the tax base is a temporary difference that will result in a deferred tax liability.

5. Legislation does not allow donations to be deducted for tax purposes. This constitutes a pennanent difference that will not have any impact on deferred taxes.

6. Interest received in advance results in a temporary difference that gives rise to a deferred tax asset. The carrying value of the liability exceeds the tax base.

7. Rent received in advance also causes a temporary difference that gives rise to a deferred tax asset.

8. No temporary differences result from loan or interest payments. Therefore, no deferred tax items are recognized.

9. The carrying value of the liability exceeds its tax base. This difference is temporary and gives rise to a deferred tax asset.

Temporary Differences at Initial Recognition of Assets and Liabilities

In some situations, the carrying value and tax base of certain assets and liabilities may not be equal at initial recognition. For example, a company may deduct a government grant from the initial carrying amount of an asset or a liability on the balance sheet. In such circumstances (even though the tax base and the carrying amount of the item are different) a company cannot recognize deferred tax assets or liabilities.

Basically, deferred tax assets or liabilities should not be recognized in cases that would arise from the initial recognition of an asset or a liability in transactions that are not a business combination and when, at the time of transaction, there is no impact on either accounting or taxable profit.

Goodwill may be treated differently across different tax jurisdictions, which may lead to differences in the carrying amount and tax base of goodwill. However, accounting standards do not permit the recognition of a deferred tax liability (due to differences between the tax base and carrying amount of goodwill) upon its initial recognition. Subsequently, deferred taxes may be recognized due to differences between the carrying amount and tax base of goodwill that arise from impairment charges.

Business Combinations and Deferred Taxes

In a business combination, if the fair value of acquired intangible assets (including goodwill) is different from their carrying amounts, deferred taxes can be recognized.

Investments in Subsidiaries, Branches, Associates, and Joint Ventures

With regard to investments in subsidiaries, branches, associates, and interests in joint ventures, deferred tax liabilities (arising from temporary differences on the consolidated versus the parent 's financial statements) can be recognized unless:

The parent is in a position to control the timing of the future reversal of the temporary difference, and It is probable that the temporary difference will not reverse in the future.

© 2017Wiley

Deferred tax assets will be recognized only if:

The temporary difference will reverse in the future, and Sufficient taxable profits exist against which the temporary difference can be used.

Unused Tax Losses and Tax Credits

Under IFRS, unused tax losses and credits may only be recognized to the extent of probable future taxable income against which these can be applied. On the other hand, under U.S. GAAP, deferred tax assets are recognized in full and then reduced through a valuation allowance if they are unlikely to be realized. A company that has a history of tax losses may be unlikely to earn taxable profits in the future against which it can apply deferred tax assets.

LESSON 3: RECOGNITION AND MEASUREMENT OF CURRENT AND DEFERRED TAX AND PRESENTATION AND DISCLOSURE

Recognition and Measurement of Current and Deferred Tax

Current taxes are based on the tax rates applicable at the balance sheet date. Deferred taxes, on the other hand, are measured at the rate that is expected to apply when they are realized (when the temporary differences that gave rise to them are expected to reverse).

Even though deferred tax assets and liabilities arise from temporary differences that are expected to reverse at some point in the future, present values are not used in determining the amounts to be recognized. Deferred taxes as well as income taxes should always be recognized unless they pertain to:

Taxes or deferred taxes charged directly to equity. A possible provision for deferred taxes related to a business combination.

Even if there has been no change in temporary differences during the current period, the carrying amount of OTA and DTL may change due to:

Changes in tax rates. Reassessments of recoverability of OTA. Change in expectations as to how the OTA or DTL will be realized.

LOS 30g: Describe the valuation allowance for deferred tax assets-when it is required and what impact it has on financial statements. Vol 3, pg 567

Recognition of a Valuation Allowance

Although DTL and OTA are created from temporary differences that are expected to reverse in the future, they are not discounted to their present values to ascertain book values. However, deferred tax assets must be evaluated at each balance sheet date to ensure that they will be recovered. If there are any doubts as to whether they will be realized, their carrying value should be reduced to the expected recoverable amount. Doubts regarding the actual realization of deferred tax assets can stem from the expectation of insufficient future taxable income to recover the tax assets (prepaid taxes).

©2017Wiley

INCOME TAXES

INCOME TAXES

Under U.S. GAAP, DTA are reduced by creating a contra-asset account known as the valuation allowance. An increase in the valuation allowance reduces deferred tax assets. The negative change in deferred tax assets results in an increase in income tax expense, which in turn translates into lower net income, retained earnings, and equity. Should circumstances subsequently change, and the likelihood of realizing deferred tax assets increase, the previous reduction in DTA can be reversed by reducing the valuation allowance.

Since the timing and amount of any reduction in value of DTA is rather subjective in nature, analysts should carefully scrutinize these changes. Analysts should also forecast a company's financial performance and gauge whether any deferred tax assets are likely to be realized.

LOS 30h: Explain recognition and measurement of current and deferred tax items. Vol 3, pp 567-569

Recognition of Current and Deferred Tax Charged Directly to Equity

Under both IFRS and U.S. GAAP, deferred tax assets and liabilities should generally have the same accounting treatment as the assets and liabilities that give rise to them. If the item that gave rise to the deferred tax asset/liability is taken directly to equity, the resulting deferred tax item should also be taken directly to equity.

If a deferred tax liability is not expected to reverse, it should be reduced, and the amount by which it is reduced should be taken directly to equity. Any deferred taxes related to business combinations should also be recognized in equity. See Example 3-1 .

Example 3-1: Taxes Charged Directly to Equity

On January I, 2005, Jeremy Builders purchased a piece of equipment for $2,000,000. For accounting purposes, it is depreciated at a rate of 5% a year on a straight-line basis. However, for tax purposes it is depreciated at a rate of 10% a year on a straight-line basis. On January I , 2007, the equipment is revalued at $2,400,000 and it is estimated that the machinery will be in use for a further 20 years after revaluation. For tax purposes, the revaluation is not recognized. Assume that the tax rate is 40% and the asset has zero salvage value for tax and financial reporting purposes.

I. Calculate the depreciation expense for the machinery for 2005 for accounting and tax purposes.

2. What is the tax base of equipment on December 31, 2005? 3. Calculate the deferred tax asset or liability on December 31, 2006. 4. Calculate the deferred tax asset or liability on December 31, 2007.

Solution

I. Depreciation expense for accounting purposes = 5% x 2,000,000 = $I 00,000

Depreciation expense for tax purposes = 10% x 2,000,000 = $200,000

©2017Wi ley

2. Tax base on January 1, 2005 Depreciation expense (tax purposes) Tax base on December 31 , 2005

$2,000,000 $200,000

$1 ,800,000

3. Canying amount on December 31, 2006 = 2,000,000- (100,000 x 2) = $1,800,000

Tax base on December 31 , 2006 = 2,000,000 - (200,000 x 2) = $1,600,000

Since the canying amount of the equipment is greater than its tax base, it gives rise to a deferred tax liability.

Deferred tax liability= (1 ,800,000 - 1,600,000) x 40% = $80,000

4. Canying amount on December 31, 2007 = 2,400,000 - 120,000 = $2,280,000. The asset was revalued upward to $2,400,000 at the beginning of 2007 and is expected to be in use for a further 20 years. Therefore, annual depreciation for financial reporting purposes is $120,000 (= $2,400,000/20).

Tax base on December 31 , 2007 = 1,600,000 - 200,000 = $1,400,000

It may seem that deferred tax liability on December 31, 2007, would amount to $352,000 (calculated as [($2,280,000 - $1,400,000) x 40%]), but this is NITT the case. Only the portion of the difference between the tax base and the canying amount that is not caused by the revaluation gives rise to a deferred tax liability.

The $600,000 revaluation is recognized only on the financial statements, not for tax purposes. The revaluation surplus and the associated tax effects are accounted for as a direct adjustment to equity. The $600,000 revaluation surplus is reduced by the tax provision associated with the excess of fair value over canying value (600,000 x 40%) = $240,000 and it affects retained earnings.

The deferred liability that should be reported on the balance sheet for 2007 is therefore not $352,000, but only $112,000 (= $352,000 - $240,000). The change in deferred tax liability over the year is $32,000 (= $112,000 - $80,000).

Finally, note that each year after the revaluation, an amount equal to depreciation arising from the revaluation minus the deferred tax effect will be transferred from the revaluation reserve to retained earnings. In 2007, for example, this amount will be calculated as the portion of annual depreciation arising from the revaluation, $30,000 ( = $600,000 I 20) minus the deferred tax effect of $12,000 (= $30,000 x 0.40), which comes to $18,000.

LOS 30i: Analyze disclosures relating to deferred tax items and the effective tax rate reconciliation and explain how information included in these disclosures affects a company's financial statements and financial ratios. Vol 3, pp 570--575

This LOS is best understood through a comprehensive example. In Exhibit 3-1 , we have included ABC Company 's income statement, balance sheet, and income tax disclosures. The questions following the financials illustrate the importance of deferred tax items.

© 2017Wiley

INCOME TAXES

INCOME TAXES

Exhibit 3-la

ABC Company Income Statement

Dec. 31, 2008 Dec. 31, 2007 Dec. 31, 2006

($) ($) ($)

Sales 5,000 4,500 4,000 Cost of goods sold 3,500 3,300 3,000 Gross profit 1,500 1,200 1,000

Total expenses (1,000) (800) (650) The tax provision Interest income 200 180 165 of S23 million isonly3 .3%of

I income before taxes Income before taxes 700 580 515 (23nOO) x 100. • • • Income tax expense

Net income after tax 677 565 461

Exhibit 3-lb

ABC Company Balance Sheet

Dec. 31, 2008 Dec. 31, 2007 ($) ($)

Assets Cash 525 425 Receivables 80 65

c,rrentdofotredtax 11 Inventories 75 55

assets. Deferred income taxes

I • • Total current assets ITJ 705 580

Noncurrent Assets Net fixed assets 1,200 1,000 Goodwill 500 400

ITJ ij5: Non current Deferred income taxes 59 ---.... deferred tax

Total Assets 2,464 2,015

Liabilities and Shareholders' Equity Accounts payable 59 102 Current portion of long-term debt 75 165 Total current liabilities 134 267

Long-term debt 1,125 1,225 ~ Noncurrent

Deferred income taxes ITJ • . ___.:erred Total liabilities 1,165 1,260 liabilities

Common stock 300 300 Retained earnings 865 188 Total Liabilities and Shareholders' Equity 2,464 2,015

@) © 2017Wiley

Exhibit 3-lc

Notes to the Financial Statements

~ Income (loss) before taxes

[lJ Income tax (provision) benefit Deferred

Income tax (provision)

Dec. 31, 2008

($)

Dec. 31, 2007

($)

580 (25) IO

•

INCOME TAXES

~ Taxes payable 1 (245) (203)

W Change in valuation allowance [jJ • -----~•~8~0-Tax credits 22 8

Income tax expense • •

Taxes payable for 2008 = 35% (tax rate) times S700 (income before taxes).

Exhibit 3-ld

Deferred Tax Assets

Operating loss carryforwards Deferred revenue Gross deferred assets Less valuation allowance Net deferred tax assets

Deferred Tax Liabilities Excess tax depreciation Other Deferred tax liabilities

Net deferred tax assets

Reported as: Current OTA Noncurrent OTA Noncurrent DTL Net deferred tax assets

© 2017Wiley

A decrease of $200 million in the valuation allowance causes an increase in net deferred tax assets, which serves to reduce income tax expense.

TP = ITE + MJTL - .IDT A

Dec. 31, 2008

($)

[iJ I 5oo 100 600

[!] I• 150

I 90 16

106

44

• i59 •

For 2008, current taxes of $45 million are offset by deferred taxes of S22 million to reduce income tax expense on the financial statements to $23 million.

Dec. 31, 2007 Operating loss

• carryforwards are the most ($) significant source of OTA.

650 I 165 815 650 I 165

Decrease in valuation allowance . over the year 650 - 450 = s• million.

105 I _______.. Accelerated tax depreciation is

25 the most significant source of DTL.

130

35 This exhibit provides details regarding the derivation of OTA and

• DTL figuresthat are shown on the balance

~ sheet

• 35

INCOME TAXES

I. What implications does the valuation allowance of $450 million against grossed deferred assets of$600 million in 2008 (Exhibit 3-ld) have on the company's future earning prospects?

2. How would the company's DTL and OTA be affected by a reduction in tax rates to 32% from 35%? Would this change benefit the company?

3. How would the company's earnings be different if it did not use a valuation allowance?

4. How would the operating loss carryforwards of$500 million (Exhibit 3-ld) affect the value a prospective buyer might pay for the company?

5. Under what circumstances should an analyst consider DTL as debt or as equity? When should an analyst exclude deferred taxes entirely from the calculation of leverage ratios?

Solution

I. The company has a valuation allowance against a significant portion of its deferred tax assets, which implies that the company does not think that it will have sufficient future earnings against which it can realize its deferred tax assets. However, it is clear from the income statement that the company is generating profits, and if this trend in profitability were to continue, it would be able to realize its deferred tax assets. In 2008, the valuation allowance decreased by $. million. The decrease in the valuation allowance increased net deferred tax assets, and reduced income tax expense by $200m to$. million. (See Exhibit 3-lc.)

2. The company currently has net deferred tax assets of$ million (see Exhibit 3-ld). A reduction in tax rates will reduce the value of these assets and hurt the company. Further, there is a possibility that there will be further downward adjustments in the valuation allowance to the extent of$. million, which will increase net deferred tax assets. In that case, the negative effect of the reduction in tax rates will be magnified.

3. The reduction in valuation allowance lowered income tax expense by $200 million in 2008. If there were no reduction in the valuation allowance in 2008, income tax expense would have been higher, and reported income lower.

4. If the acquiring company is profitable, it could use the company's significant operating loss carryforwards to offset its own deferred tax liabilities. The acquirer would be willing to pay the present value of the tax savings (based on its own tax rate) that it could realize against ABC's loss carryforwards. The higher the acquirer's tax rate, and the more profitable the acquirer, the sooner it will be able to benefit.

5. If the deferred tax liability will reverse with an eventual tax payment, it should be treated as a liability. However, if reversal is not expected, and there is no expectation of an eventual cash outflow, the liability should be treated as equity. This could happen because of a reduction in tax rates in the future or expected future losses. When the amount and timing of reversal of temporary differences are uncertain, analysts should exclude DTL from both debt and equity in their analysis.

9 ©2017Wiley

Example 3-2: Statutory U.S. Federal Income Tax Rate Reconciliation

Winterfell Inc. is a U.S.- based telecom company. The company faces a statutory tax rate of 35%. Its reconciliation between statutory and effective income taxes is provided below.

Income Tax Reconciliation

2012 2011 2010

Taxable income $2,080 $2,360 $2,940

U.S. federal income tax (provision) benefit at statutory rate 728 826 1,029

State taxes, net of federal benefit 40 50 70

Benefits and taxes related to foreign operations (165) (150) (125)

Tax credits 4 16

Export sales benefit 3 (15) 11

Other (5) 23 (17)

Effective income taxes 557 750 976

Calculate the effective tax rates for Winterfell for each of the three years. Also comment on the trend in effective tax rates over the period.

Solution

The analysis of effective tax rates can be based on absolute amounts and/or on percentages. We present percentage numbers as well as effective income tax rates in this table:

2012 2011 2010

U.S. federal income tax (provision) benefit at 35% 35.00% 35.00% 35.00%

State taxes, net of federal benefit 1.92% 2.12% 2.38%

Foreign operations (7.93%) (6.36%) (4.25%)

Tax credits 0.19% 0.68% 0.27%

Export sales benefit 0.14% (0.64%) 0.37%

Other (0.24%) 0.97% (0.58%)

Effective income tax rates 26.78% 31.78% 33.20%

The effective tax rate exhibits a downward trend over the three-year period.

The (I) decrease in the state income tax rate and (2) increase in benefits related to foreign income contribute to the downward trend. During each of the three years benefits from export sales and other items partially offset each other. The volatility in these two items makes it difficult to forecast the effective tax rate for Winterfell going forward and reduces the comparability of its financial statements with peer companies.

©2017Wiley

INCOME TAXES

INCOME TAXES

LOS 30j: Identify the key provisions of and differences between income tax accounting under International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (GAAP). Vol 3, pp 575-578

IFRS

Issue-Specific Treatments

Revaluation of Recognized in equity as deferred fixed assets and taxes. intangible assets.

Treatment of undistributed profits from investment in subsidiaries.

Treatment of undistributed profits from investments in joint ventures.

Treatment of undistributed profits from investments in

Recognized as deferred taxes except when the parent company is able to control the distribution of profits and it is probable that temporary differences will not reverse in the future.

Recognized as deferred taxes except when the investor controls the sharing of profits and it is probable that there will be no reversal of temporary differences in the future.

Recognized as deferred taxes except when the investor controls the sharing of profits and it is probable that there will be no reversal of

associates. temporary differences in the future.

Deferred Tax Measurement

Tax rates.

Deferred tax asset recognition.

Tax rates and tax laws enacted or substantively enacted.

Recognized if it is probable that sufficient taxable profit will be available in the future.

Deferred Tax Presentation

Offsetting of deferred tax assets and liabilities.

Balance sheet classification.

Offsetting allowed only if the entity has right to legally enforce it and the balance is related to tax levied by the same authority.

Classified on the balance sheet as net noncurrent with supplementary disclosures.

U.S.GAAP

Revaluation is prohibited.

No recognition of deferred taxes for foreign subsidiaries that fulfill the indefinite reversal criteria.

No recognition of deferred taxes for domestic subsidiaries when amounts are tax free.

No recognition of deferred taxes for foreign corporate joint ventures that fulfill the indefinite reversal criteria.

Deferred taxes are recognized from temporary differences.

Only enacted tax rates and tax laws are used.

Deferred tax assets are recognized in full and then reduced by a valuation allowance if it is like I y that they will not be realized.

Similar to IFRS.

Classified as either current or noncurrent based on classification of underlying asset and liability.

© 2017Wiley

NON-CURRENT (LONG· TERM) LIABILITIES

READING 31: NON-CURRENT (LONG-TERM) LIABILITIES

LESSON 1: BONDS PAYABLE

Financing Liabilities: Terminology

A bond is a contract between a borrower and a lender that obligates the borrower to make payments to the lender over the term of the bond. Two types of payments are usually involved- periodic interest payments and principal repayments. Before we get into the analysis of financing liabilities, we must understand the following terms:

Par or face value: This is the amount that the borrower must pay back investors at maturity. The par value is not necessarily the amount that the borrower receives upon issuing debt.

Coupon rate (nominal or stated rate): This is multiplied by the par value of the bond to determine the periodic coupon payment.

Market interest rates are used to value bonds. These rates incorporate various types of risks inherent in the bond, and must not be confused with coupon rates. Market interest rates change from day to day.

The value of a company's debt obligations at any point in time, t, equals the present value of all remaining payments discounted at current market interest rates (mii). However, for accounting purposes, the book value of the liability recognized on the issuer's balance sheet equals the present value of its obligations discounted at market interest rates at issuance (mi0) . Market interest rates at issuance determine how much the company receives in bond proceeds from the issuance ofbonds. The market rate at the time of issuance is the effective interest rate on the loan.

At issuance, the market rate can be the same as or different than the coupon rate.

If the market interest rate is the same as the bond's coupon rate, the bond will be issued at par. If the market interest rate is greater than the coupon rate, the bond will be issued at a discount. Since the coupon rate on offer is less than the compensation required by market participants, the bond will sell for less than its face value. If the market interest rate is lower than the coupon rate, the bond will be issued at a premium. Since the coupon rate on offer exceeds the compensation required by the market, the bond will sell for more than its face value.

Finally, interest expense (recognized on the income statement) under the effective interest method for a given period is calculated as the book value of the liability at the beginning of the period multiplied by the market interest rate at issuance (mi0). It is not the coupon payment (actual periodic cash outflow) that is recognized as interest expense on the income statement.

©2017Wiley

The market rate of interest at the time of issue often differs from the coupon rate because of interest rate fluctuations that occur between the time the issuer establishes the coupon rate and the day the bonds are actually available to the investors.

Formulas

Bond proceeds at issuance (t = 0): BV0 = PV (cash flows) discounted atmi0

Market value of bonds at time. t: PV (cash flows) discounted at mi1

Coupon payment: Periodic coupon rate xParvalue

Interest expense: mia x Book value of liability at the beginning of the period.


LOS 31a: Determine the initial recognition, initial measurement and subsequent measurement of bonds. Vol 3, pp 588-599

LOS 31b: Describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments. Vol 3, pp 588-599

There are two methods of accounting for noncurrent liabilities.

The effective interest method results in a constant rate of interest over the life of the bond. It is required under IFRS and preferred under U.S. GAAP. Under this method, the market interest rate at issuance is applied to the carrying amount of the bonds to determine periodic interest expense. Further, the difference between interest expense and the actual coupon payment equals the amount of discount/premium amortized over the period.

The straight-line method, which is also permitted under U.S. GAAP, evenly amortizes the premium or discount over the life of the bond (similar to straight-line depreciation).

The financial statement effects of bond issuance, as well as the effective interest and straight-line methods of amortizing bond premiums and discounts are illustrated in Example 1-L

Example 1-1: Accounting for Financing Liabilities

Alan Company plans to issue bonds worth $100,000 par with a 10% annual coupon and a 4-year maturity. The amount of bond proceeds received by the company depends on market interest rates at issuance. We will work with three scenarios to illustrate the differences in accounting and analysis of par bonds, premium bonds, and discount bonds under the effective interest method.

© 2017Wiley

Scenario A: Market Interest Rates at Issuance = 10%

The amount of bond proceeds equals the present value of the bond's cash flows discounted at market interest rates at issuance (I 0% ).

FY= $100,000; N = 4; llY = 10; PMT = $10,000; CPT PV; PV ->-$100,000

Cash flows from bonds: Alan will receive $100,000 for these bonds today. Alan will pay an annual coupon of $10,000 for 4 years. At the end of Year 4, Alan will return the par value ($100,000) to investors.

Interest Expense and Book Value of Par Bond (Effective Interest Method)

Market interest rate Coupon Interest at issuance times rate times the expense minus

beginning liability. par value. coupon.

Beginning Interest Coupon Change in Closing Year Liability Expense Payment Liability Liability

$ $ $ $ $

0 0 100,000

100,000 10,000 10,000 0 100,000 2 100,000 10,000 10,000 0 100,000

100,000 10,000 10,000 0 100,000 4 100,000 10,000 10,000 0 100,000

Total 40,000 40,000


NON-CURRENT (LONG-TERM) LIABILITIES

Balance sheet: The year-end value of the liability is listed on the balance sheet. For bonds issued at par, the liability balance remains at par throughout the life of the bond ($100,000 every year).

Income statement: Interest expense is deducted from operating income. For bonds issued at par, interest expense equals the coupon payment, and is constant over the life of the bond ($10,000 every year).

Statement of cash flows: At issuance, bond proceeds are reported as inflows from financing activities. During the tenure of the bond, coupon payments (not interest expense) are deducted from cash flow from operating (CFO) activities. At maturity, cash used to repay the principal amount (par value) is deducted from cash flow from financing (CFF) activities.

For bonds issued at par, the inflows recorded at issuance under CFF equal the outflows from CFF at maturity. Coupon payments are deducted from CFO every year.

©2017Wiley


lmp:irtantShortcut 1:

Interest expense over the term of the bond can be calculated as all the issuer's outflows over the life of the bond (coupon payments plus principal repayment) minus the inflows received at issuance (bond proceeds). Total interest expense over the 4 yearn:

SI 00,000 + $40,000 - S96,898 = $43, 102

Year 2 beginning liability equals Year I closing liability.

If the straight-line method were used, the discount would be evenly amortized over the term of the bonds. ln this scenario, the discount of S3,l02 would be amortized by $775.50 each year. Annual interest expense under the straight-line methcxl would be S 10,000 + S775.50 = SI0,775.50.

Scenario B: Market Interest Rates at Issuance = 11 %

Calculation of bond proceeds:

FV = $100,000; N = 4; I/Y = 11; PMT = $10,000; CPT PV; PV--; -$96,897.55

Cash flows from bonds: . Alan will receive $96,898 for these bonds today . . Alan will pay an annual coupon of $10,000 for 4 years . . At the end of the Year 4, Alan will return the par value ($100,000) to investors; not the issuance proceeds ($96,898).

Interest Expense and Book Value of Discount Bond (Effective Interest Method)

Market interest rate at Interest expense Beginning of year value issuance times beginning- minus coupon of liability plus change of-year value of liability. payment. in liability over the year.

Proceeds from bond ForYearl: ForYearl: ForYearl: issuance. 11 % x $96,898 $ 10,659 - $ 10,000 $96,898 + $659

-


$ $ $ $ $ - ---

0 96,898

1 - 96,898 - 10,659 10,000 - 659 ~ 97,556

2 97,556 10,731 10,000 731 98,287

3 98,287 10,812 10,000 812 99,099

4 99,099 10,901 10,000 901 100,000

Total 43,103 40,000 3,103

Every year, Alan pays out less in the form of coupon (cash outflow of $10,000) than it owes in interest expense (e.g., $10,659 in Year 1). This shortfall serves to increase the value of the liability over the period (e.g., the liability increases by $659 over Year 1).


Balance sheet: For bonds issued at a discount, the book value of the liability increases over the life of the bond. The entire discount ($3,102) is amortized over the 4 years. The value of the liability at the end of Year 4 equals par value, which is the amount that must be paid to investors at maturity.

Income statement: Interest expense rises from year to year in line with the increasing book value of the liability.

Statement of cash flows: For bonds issued at a discount, the inflow recorded at issuance under CFF ($96,898) is lower than the outflow from CFF at maturity ($100,000). Coupon payments ($10,000) are deducted from CFO every year.

© 2017Wiley


Scenario C: Market Interest Rates at Issuance = 9%

Calculation of bond proceeds:

FV = $100,000; N = 4; I/Y = 9; PMT = $10,000; CPT PY; PY~ -$103,239.71

Cash flows from bonds: Alan will receive $103,240 for these bonds today. Alan will pay an annual coupon of $10,000 for 4 years. At the end of Year 4, Alan will return the par value ($100,000) to investors; not the initial proceeds from sale ($103,239.71).

Interest Expense and Book Value of Prentium Bond (Effective Interest Method)

Year

0 1 2 3 4

Total

Market interest rate at issuance times beginning of year liability.

For Year I: Proceed' from bond issuance. 9% x $103,240

Beginning Liability

$

- 103,240 102,531 101,759 100,917

Interest Expense

-

$

9,292 9,228 9,158 9,083

36,760

Interest expense minus coupon payment.

ForYearl: $9,292- $10,000

Coupon Payment

$

Beginning of year value of liability plus change in liability.

For Year I: $103,240 + (- $708)

Change in Closing Liability Liability

$ $ 103,240

10,000 10,000 10,000 10,000

~- -708 -772

~ 102,531 101,759 100,917 100,000

-842 -917

40,000 -3,240

Every year, Alan pays out more in the form of coupon (cash outflow of $10,000) than it owes in interest expense (e.g., $9,292 in Year 1). This excess payment serves to decrease the book value of the liability each year (e.g., by $708 in Year 1).

Effect on Financial Statements

Balance sheet: For bonds issued at a premium, the book value of the liability decreases over the life of the bond. The entire premium ($3,240) is amortized over the 4 years. The value of the liability at the end of Year 4 equals the par value, which is the amount that must be paid to investors at maturity.

Income statement: Interest expense declines every year in line with the decreasing book value of the liability.

Statement of cash flows: For bonds issued at a premium, the inflow recorded at issuance under CFF ($103,240) is greater than the outflow from CFF at maturity ($100,000). Coupon payments ($10,000) are deducted from CFO every year.

©2017Wiley

lmJXlrtant Shortcut 2

To detennine the book value of the liability at any point in time, simply compute the present value of the bond's remaining cash flows, discounting them at market interest rates at issuance.

Closing Liability (Year2):FV= $100,000; PMT = $10,000; N = 2; UY =9CPTPV;PV= $101,759

If the straight-line method were used, the premium would be evenly amortized over the term of the bonds. In this scenario, the premium of $3,240 would be amortized by S810 each year. Annual interest expense under the straight-line method would be $10,000 -$810=$9,190.


Notice that for zero coupon bonds, interest expense each year equals the amount of discount amortized each year.

Zero-Coupon Bonds

Zero-coupon bonds accrue interest over their terms. No coupon payments are made and the lump sum payment at maturity includes repayment of principal and interest. Zero-coupon bonds are steeply discounted instruments because coupon rates (zero) fall significantly short of the compensation required by the market (market interest rate at issuance) for investing in them.

Example 1-2: Zero-Coupon Bonds

A company issues a 4-year, $100,000 par, zero-coupon bond when market interest rates equal 10%. Calculate the proceeds from bond issuance, the periodic interest expense, and the closing value of the liability at the end of each year.

Solution

The amount that the company receives upon bond issuance equals $68,301 (FY= -$100,000: N = 4 ; I/Y = 10%; PMT = O; CPT PY; PY--; $68,301). Annual interest expense and the closing values of the liability are calculated below:


0 68,301

68,301 6,830 0 6,830 75,131

2 75,131 7,513 0 7,513 82,645

3 82,645 8,265 0 8,265 90,909

4 90,910 9,091 0 9,091 100,000

Total 31,699 0 31,699

Treatment of Noncurrent Liabilities under U.S. GAAP and IFRS

Costs like printing, legal fees, and other charges are incurred when debt is issued. Under IFRS, these costs are included in the measurement of the liability. Under U.S. GAAP on the other hand, companies usually capitalize these costs and write them off over the bond's term. Therefore, the liability value recognized on the balance sheet equals the amount of sales proceeds.

Under IFRS and U.S. GAAP, cash outflows related to bond issuance costs are usually netted against bond proceeds and reported as financing cash flows.

U.S. GAAP requires interest payments on bonds to be classified under CFO. IFRS allows more flexibility in that classification of interest payments as CFO or CFF is permitted. Typically cash interest payments are not disclosed on the face of the cash flow statement, but companies are required to disclose interest paid separately.

Amortization of the bond discount/premium is a noncash item so it has no effect on cash flows (aside from the effect on taxable income). In the reconciliation of net income to operating cash flow, amortization of a discount (premium) is added back to (deducted from) net income.

© 2017~ 1ey

NON·CURRENT (LONG· TERM) LIABILITIES

Fair Value Reporting Option

When a company uses the effective interest method to amortize bond discounts and premiums, the book value of debt is based on market interest rates at issuance. Over the life of the bonds, as market interest rates fluctuate the actual value of the firm 's debt deviates from its reported book value. For example, if interest rates rise, the current market value of debt would fall. The reported book value of debt (based on the market interest rates at issuance) would be higher than the true economic value of the firm's obligations. In this case, using the book value will overstate leverage levels as the firm is actually better off than its financial statements indicate.

Two companies with identical book values of debt could have issued debt in very different circumstances. One could have issued debt at lower and older interest rates, while the other may have issued debt at higher current rates. The former is in the better economic position because the true economic value of its obligations is lower.

Recently, companies have been allowed to report financing liabilities at fair value. Companies that choose to report their financing liabilities at fair value report gains (losses) on their profit and loss statements (P&Ls) when market interest rates increase (decrease) as the carrying value of their obligations (liabilities) falls (rises).

If fair values are not explicitly reported on the financial statements, IFRS and U.S. GAAP both require companies to disclose the fair value of their financing liabilities. An analysis of a company could be materially affected if the company's reported carrying amount of debt (based on amortized cost) is significantly different from the fair value of its liabilities.

LOS 31c: Explain the derecognition of debt. Vol 3, pp 599-601

Derecognition of Debt

A company may leave the bonds that it issues outstanding until maturity or retire them prior to maturity by either purchasing them from the open market or calling them (if a call provision exists). If the company leaves the bonds outstanding until maturity, it pays investors the par value of the bonds at maturity.

However, if the company decides to retire the bonds prior to maturity, the book value of the liability is reduced to zero and a gain or loss on extinguishment is computed by subtracting the amount paid to retire the bonds from their book value. For example, if a liability with a book value of $5 million is retired before maturity for $5.25 million, there is a loss on extinguishment of $0.25 million.

Under U.S. GAAP, because issuance costs are capitalized any unamortized issuance costs must also be subtracted from gains on extinguishment. Under IFRS, issuance costs are included in the book value of the liability so there is no need to adjust the gain on extinguishment for these expenses.

©2017Wiley

Reporting standards for financial investments and derivatives require companies to report a significant portion oftheirassetsatfair values. Measuring financial liabilities at other than fair value, when financial assets are measured at fair value, results in earnings volatility. This volatility is the result of using different bases of measurement for financial assets and financial liabilities.

Few companies opt toreIXJrtdebtat fair values on the balance sheet.

Most companies report the fair values of financial liabilities in disclosures.

The primary exception to the disclosure occurs when fair value cannot be reliably measured.


A comprehensive example discussing the financial statement presentation and disclosures relating to debt is included in our practice questions.

The gain or loss on extinguishment is reported as a separate line item on the income statement if significant, and more details regarding the redemption are discussed in the management discussion & analysis (MD&A) section. Cash paid to redeem the bond is classified as a financing cash outflow.

If the indirect method is used to report cash flow from operating activities, net income is adjusted for the gain (loss) on extinguishment by subtracting (adding) it as it arises from nonoperating activities.

LOS 31d: Describe the role of debt covenants in protecting creditors. Vol 3, pp 601--003

Debt contracts often include clauses that protect bondholders by lintiting the issuer's ability to invest, pay dividends, or make other strategic and operating decisions. These restrictions or covenants also benefit borrowers (issuers) in that they reduce default risk and lower the cost of borrowing. Common covenants include:

Maintenance of pledged collateral. Restrictions on dividend payments. Requirements to meet certain working capital levels. Maximum levels of leverage.

When a company violates a covenant it is said to be in default. In the event of default, bondholders can choose to waive the covenant, renegotiate, or call for repayment. Covenants are discussed in more detail in the Fixed Income section.

LOS 31e: Describe the financial statement presentation of and disclosures relating to debt. Vol 3, pp 603-606

On the balance sheet, long-term liabilities are listed as one aggregate figure for all liabilities due after one year. Liabilities due within one year are included in short-term liabilities (current liabilities). Financial statement footnotes provide more information on the nature and types of long-term debt issued by the company. They usually include:

Stated and effective interest rates. Maturity dates. Restrictions imposed by creditors (covenants). Pledged collateral. Scheduled repayments over the next 5 years.

More information regarding a firm 's debt and off balance-sheet financing sources can be found in the MD&A section. The information in the footnotes and MD&A section can be used to forecast patterns and levels of future cash flows.

© 2017Wiley


LESSON 2: LEASES

LOS 31f: Explain the motivations for leasing assets instead of purchasing them. Vol 3, pp 60~07

A lease is a contract between the owner of the asset (lessor) and another party that wants to use the asset (lessee). The lessee gains the right to use the asset for a period of time in return for periodic lease payments. Leasing an asset holds the following advantages over purchasing the asset:

Leases often have fixed interest rates. They require no down payment so they conserve cash. At the end of the lease, the asset can be returned to the lessor so the lessee escapes the risk of obsolescence and is not burdened with having to find a buyer for the asset. The lessor may be in a better position to value and dispose of the asset. Negotiated lease contracts usually have less restrictions than borrowing contracts. The lessor can take advantage of the tax benefits of ownership such as depreciation and interest. In the United States, leases can be structured as synthetic leases, where the company can gain tax benefits of ownership while not reflecting the asset on its financial statements.

LOS 31g: Distinguish between a finance lease and an operating lease from the perspectives of the lessor and the lessee. Vol 3, pp 607-624

LOS 31h: Determine the initial recognition, initial measurement, and subsequent measurement of finance leases. Vol 3, pp 607-624

Lessee's Perspective

U.S. GAAP requires a lessee to classify a lease as a capital lease if any of the following conditions hold:

I. The lease transfers ownership of the asset to the lessee at the end of the term. 2. A bargain purchase option exists. 3. The lease term is greater than 75% of the asset's useful economic life. 4. The present value of the lease payments at inception exceeds 90% of the fair value

of the leased asset.

If none of these conditions hold, the lessee may treat the lease as an operating lease.

Under IFRS, classification of a lease depends on whether all the risks and rewards of ownership are transferred to the lessee. If they are, the lease is classified as a finance lease; if they are not, the lease is classified as an operating lease.

Operating Lease (Lessee's Perspective)

The accounting treatment for an operating lease is similar to that of simply renting an asset for a period of time. The asset is not purchased; instead, payments are made for using it.

©2017 Wiley

Finance lease is lFRS terminology and capital lease isU.S.GAAP terminology.


Under an operating lease, no lease-related entries are made on the balance sheet The firm has effectively rented a piece of equipment. It has not purchased the asset so there is no addition to fixed assets, and it has not borrowed any money to finance the purchase, so there are no related liabilities.


Balance sheet: None, because no asset or liability is recognized. Income statement: None, because the asset has not been used yet. Cash flow statement: None, because there has been no cash transaction.

Accounting Entries Every Year During the Term of the Lease

Balance sheet: None, because no lease-related assets and liabilities are recognized. Income statement: Leasehold (rental) expense is charged every year. Cash flow statement. The lease payment is classified as a cash outflow from operating activities.

Capital or Finaoce Lease (Lessee's Perspective)

A finance lease requires the company to recognize a lease-related asset and liability on its balance sheet at inception of the lease. The accounting treatment for a finance lease is similar to that of purchasing an asset and financing the purchase with a long-term loan.


Balance sheet: The present value of lease payments is recognized as a long-lived asset. The same amount is also recognized as a noncurrent liability. Income statement: None because the asset has not been used yet. Cash flow statement: None because no cash transaction has occurred. Disclosure of lease inception is required as a "significant noncash financing and investing activity."

Accounting Entries Every Year During the Term of the Lease

Balance sheet: The value of the asset falls every year as it is depreciated. Interest is charged on the liability as the appropriate discount rate times the beginning-of-year value of the liability. The excess of the lease payment over the year's interest expense reduces the liability. Income statement: Depreciation expense (against the asset) and interest expense (on the liability) are charged every year. Cash flow statement. The portion of the lease payment equal to the interest expense is subtracted from CFO, while the remainder that serves to reduce the liability is subtracted fromCFF.

© 2017Wiley


Example 2-1: Lease Classification by Lessees

ABC Company leases an asset for 4 years, making annual payments of $10,000. The appropriate discount rate is 7%. Illustrate the effects on the financial statements if the lease is classified as a finance lease and an operating lease.

Solution

First let us work through the effects on the financial statements of the lessee if the lease is classified as a finance lease.

The present value of the lease payments is recognized as an asset and a liability. The PY of the lease payments equals $33,872 (PMT; $10,000; N; 4; UY; 7; CPT PY).

The table below illustrates the calculation of periodic interest expense and the ending value of the liability for a finance lease:

Beginning liability minus ~ - principal repayment. The

Discount rate times the excess of the lease payment value of the liability Lease payment over interest expense serves at the beginning of the minus interest to retire a portion of the period. component liability every year.

I Present value of I For Year I: For Year I : ForYearl: lease payments. 7% x $33,872 $10,()((1 - $2,371 $33,872 - $7,629

Beginning Principal Closing Year Liability Interest Repayment Liability

$ $ $ $

1 ~33,872 ~ 2,371 ~7,629 ~ 26,243

2 26,243 1,837 8,163 18,080

3 18,080 1,266 8,734 9,346

4 9,346 654 9,346 0

There are two ways to calculate the ending value of the liability for any period:

1. Opening liability minus the excess of the lease payment over the period's interest expense. For Year 1: 33,872 - (10,000 - 2,371); $26,243

2. Present value of remaining lease payments. For Year 1: N; 3, UY; 7, PMT; $10,000, CPT PY; PY; $26,243

In an operating lease, no lease-related asset or liability is recognized on the balance sheet of the lessee. The lease payments are classified as operating expenses on the income statement.

Now let us compare the effects on the lessee's financial statements of classifying a lease as an operating or finance lease (see Tables 2-1- 2-6):

Balance Sheet

Value of asset recognized at inception; $33,872 (Present value of lease payments). Annual depreciation (Straight-line); $8,468

© 2017Wiley


Portion of liability that will be retired within one year is classified as a current liability.

! Portion of liability that will be retired in more than a year's time is classified as a long-term liability.

YearO Year 1 Year2 Year3 Year4

$ $ $ $ $

Assets Leased assets 33 ,872 33,872 33,872 33,872 33,872 Accumulated depreciation 0 8,468 16,936 25,404 33,872 Net leased assets 33,872 25,404 16,936 8,468 0

Liabilities Current portion of lease obligation 7,629 8,163 8,734 9,346 0 LT debt: Lease obligation 26,243 18,080 9,346 0 0

Total liabilities 33,872 26,243 18,080 9,346 0

Table 2-1: Balance Sheet Effects of Lease Classification

Balance Sheet Item Finance Lease Operating Lease

Assets Higher Lower

Current liabilities Higher Lower

Long-term liabilities Higher Lower

Total cash Same Same

Income Statement

In an operating lease, the annual lease payment is recognized as an operating expense, while in a finance lease, the asset is depreciated and interest expense is charged against operating income (EBIT).


Depreciation Interest Total Expense Expense Expense Rent Expense Total Expense

Year $ $ $ $ $ 8,468 2,371 I0,839 10,000 I0,000

2 8,468 1,837 I0,305 10,000 I0,000

3 8,468 1,266 9,734 I0,000 I0,000

4 8,468 654 9,122 10,000 I0,000

TOTAL 33,872 6,128 40,000 40,000 40,000

Table 2-2: Income Statement Effects of Lease Classification

Income Statement Item

Operating expenses

Nonoperating expenses

EBIT (operating income)

Total expenses: early years

Total expenses: later years

Net income: early years

Net income: later years

Finance Lease

Lower (Depreciation)

Higher (Interest expense)

Higher

Higher

Lower

Lower

Higher

Operating Lease

Higher (Lease payment)

Lower (None)

Lower

Lower

Higher

Higher

Lower

©2017Wiley



Under an operating lease, the lease payments are deducted from CFO, while for a finance lease the interest expense portion of the lease payment is deducted from CFO and the remainder that serves to decrease the value of the liability is deducted from CFF.


CFO CFF Total CFO Year $ $ $ $

I -2,371 -7,629 -10,000 -10,000

2 -1 ,837 -8,163 -10,000 -10,000

-1,266 -8,734 -10,000 -10,000

4 -654 -9,346 -10,000 -10,000

Table 2-3: Cash Flow Effects of Lease Classification

CF Item

CFO

CFF

Total cash flow

Finance Lease

Higher

Lower

Same

Operating Lease

Lower

Higher

Same

Table 2-4: Impact of Lease Classification on Financial Ratios

Numerator Denominator Under Under

Ratio Finance Lease Finance Lease Effect on Ratio

Asset turnover Sales- same Assets- higher Lower

Return on assets Net income- Assets- higher Lower (ROA)* lower

Current ratio Current assets- Current Lower same liabilities-

higher

Leverage ratios Debt- higher Equity- same Higher (DIE and D/A3) Assets- higher

Return on equity Net income- Equity- same Lower (ROE)* lower

Ratio Better or Worse Under Finance Lease

Worse

Worse*

Worse

Worse

Worse

**Notice that both the numerator and the denominator for the DIA ratio are higher when classifying the lease as a finance lease. Beware of such exam questions. When the numerator and the denominator of any ratio are heading in the same direction (either increasing or decreasing), determine which of the two is changing more in percentage terms. If the percentage change in the numerator is greater than the percentage change in the denominator, the numerator effect will dominate.

Firms usually have lower levels of total debt compared to total assets. The increase in both debt and assets by classifying the lease as a finance lease will lead to an increase in the debt to asset ratio because the percentage increase in the numerator is greater.

©2017Wiley

*In early years of the lease agreement.

Note: Lower ROE under a finance lease isduetolowernet income (numerator effect), while lower ROA is primarily due to higher assets (denominator effect).


When the lease is classified as an operating lease, the asset is listed on the balance sheet of the lessor, who continues to depreciate it. No lease-related asset shows up on the lessee's balance sheet.

When the lease is classified as a finance lease, the lessor removes the long-lived asset from its balance sheet, and instead records a receivable in its books. The lessee records the long-lived asset on its balance sheet and depreciates it.

Lessor's Perspective

Under IFRS, the lessor must classify the lease as a finance lease if all the risks and rewards of ownership are transferred to the lessee.

Under U.S. GAAP, lessors are required to recognize capital leases when any one of the four previously mentioned criteria for recognition of a capital lease by the lessee hold, and the following two criteria also hold:

I. Collectability of the lease payments is predictable. 2. There are no significant uncertainties regarding the amount of costs still to be

incurred by the lessor under the provisions of the lease agreement.

Leases not meeting these criteria must be classified as operating leases because the earning process is not complete.

If the lessor classifies the lease as an operating lease, it records lease revenue when earned, continues to list the asset on its balance sheet, and depreciates it every year on its income statement. If the lessor classifies the lease as a finance lease, it records a receivable equal to the present value of lease payments on its balance sheet and removes the asset from long-lived assets in its books.

Finance Leases

Under U.S. GAAP, lessors can classify finance leases into two types:

1. Some manufacturers offer their customers financing options to purchase their products. These sales-type leases result in a gross profit (the normal selling price of the product minus its cost), which is recognized at inception of the lease, and interest income as payments are received over the lease term. In a sales-type lease, the present value of lease payments equals the selling price of the asset

2. Financial institutions and leasing companies offer financial leases that generate interest income only. These are known as direct financing leases, where the present value of lease payments equals the carrying value of the asset Further, there is no gross profit recognition at lease inception.

Example 2-2: Operating Lease Versus Direct Financing Lease-Lessor's Perspective

A company leases out a piece of equipment for 4 years in return for a lease payment of $10,000 every year. At the end of the lease term the asset will have no salvage value. The discount rate applicable is 6% and the carrying value of the leased asset is $34,65 L

Solution

We must calculate the present value of lease payments to determine whether the lease should be classified as a sales-type lease or a direct financing lease.

© 2017Wiley


The present value of lease payments equals $34,651 (PMT = $10,000; UY = 6; N = 4; FV = O; CPT PV), which equals the carrying value of the asset on the lessor's books. Therefore, this is a direct financing lease.

At inception, the lessor removes the carrying value of the equipment from long-lived assets in its books (derecognizes the asset). Instead, the lessor recognizes a lease receivable asset equal to the present value of lease payments.


Opening lease receivable adjusted for the

The discount rate multiplied The excess of the annual I reduction in lease by the opening balance of lease payment over receivable over the

I The pre,ent volue of I lease receivable account. interest income. year. the lease payments I This asset is reported I receivable over the For Year I : For Year 1: For Year I : on the balance sheet.

term of the lease. 6% x $34,65 1 10,000 - 2,079 34,65 1 - 7,921


Year Receivable Income Payment Receivable Receivable $ $ $ $ $

I - 34,651 - 2,079 10,000 - 7,921 26,730 -2 26,730 1,604 10,000 8,396 18,334

~3 18,334 1,100 10,000 8,900 9,434 4 9,434 566 10,000 9,434 0

TOTAL 5,349 40,000 34,651

~~ 3, the lessee owed the company interest of$1 ,100. However, the total payment made by the lessee in 9 0,000. The excess ($10,000-$ 1, l 00) reduced the total receivable amount.

Effects on Income Statement In an operating lease, the lessor realizes rental income

Depreciable value = $34,651 every year, and charges depreciation expense on the

Life of asset = 4 years asset leased out

Annual depreciation= $8662.75 i Direct Financing Lease Operating Lease

Year Income Revenue Depreciation Income ($) ($) ($) ($)

1 Interest income ~ 2,079 10,000 8,662.75 1,337.25 2 Interest income f- 1,604 10,000 8,662.75 1,337.25 3 Interest income 1,100 10,000 8,662.75 1,337.25 4 Interest income 566 10,000 8,662.75 1,337.25

TOTAL $5,349 $5,349

• In the m ly ycfil"S, highoc income i' recognized 11 Total income ovoc the I Higher income is recognized in under a direct fi nancing lease. This results in term of the lease is later years under an operating more taxes being paid out sooner. the same across both lease. Payment of taxes is therefore,

classifi cations. delayed for a period.

© 2017Wiley


Effects on Cash Flow Statement

Direct Financing Lease Operating Lease Total cash flow over the lease term is the same under

Year -CFO CFI- Total CFO both classifications. Notice

1 $2,079 $7,921 $10,000 $10,000 however, that CFO is higher under an operating lease

2 1,604 8,396 10,000 10,000 while CA is higher under a financing lease.

3 1,100 8,900 10,000 10,000 4 566 9,434 10,000 10,000

TOTAL $5,349 $34,651 $40,000 $40,000

I I Reduction in !me I I Interest income is a cash I receivable asset is a cash inflow from operations. inflow from investing

activities.

Table 2-5: Financial Statement Effects of Lease Classification from Lessor's Perspective

Financing Lease Operating Lease

Total net income Same Same

Net income (early years) Higher Lower

Taxes (early years) Higher Lower

Total CFO Lower Higher

Total CF! Higher Lower

Total cash flow Same Same

Sales-Type Leases

In a sales-type lease, the present value of lease payments is greater than the carrying value of the asset in the lessor's books. Consequently, the lessor recognized a gross profit equal to the difference between the two in the year of inception, and recognizes interest income over the term of the lease.

Example 2-3: Sales-Type Leases

A company leases out a piece of equipment for 4 years in return for a lease payment of $10,000 every year. At the end of the lease term, the asset will have no salvage value. The discount rate applicable is 6% and the carrying value of the asset is $30,000.

Solution

Notice that we are working with sintilar numbers as in Example 2-2. We have only changed the carrying value of the asset on the lessor's books to $30,000 in this example.

Since the present value of lease payments (which we have previously calculated as $34,651) is greater than the carrying value of the asset, this is a sales-type lease.

At the inception, the lessor will recognize a gross profit of $4,651 (34,651 - 30,000).

© 2017Wiley


The lessor also recognizes interest income over the term of the lease. Notice that interest income is the same as we had calculated in the direct financing lease in Example 2-2. We only changed the carrying value of the asset in this example to illustrate that under a sales-type lease, in addition to interest income the lessor also recognizes a gross profit on sale that increases total income over the lease, and results in a significant contribution to profits at inception.



Year Receivable Income Payment Receivable Receivable

I $34,651 $2,079 $10,000 $7,921 $26,730

2 26,730 1,604 10,000 8,396 18,334

18,334 1,100 10,000 8,900 9,434

4 9,434 566 10,000 9,434 0

TOTAL $5,349 $40,000 $34,651

Under IFRS, the present value of the lease payments receivable is recognized as a net investment in the lease asset. The leased asset is derecognized and removed from noncurrent assets.

For lessors that are manufacturers or dealers, initial direct costs are expensed when the selling profit is recognized (typically at inception of the lease).

Sales revenue equals the lower of fair value and the present value of minimum lease payments. The cost of sale equals the carrying amount of the leased asset minus the present value of the expected salvage value.

LOS 3li: Compare the disclosures relating to finance and operating leases. Vol 3, pp 607-624

Disclosures

Under U.S. GAAP, given the explicit standards required to classify a lease as a capital lease, companies can easily structure the terms of a lease in a manner that allows them to report it as an operating lease (it must simply ensure that none of the four capital leaseclassifying criteria are met in the terms of the lease).

Lease disclosures require a company to list the lease obligations of the firm for the next 5 years under all operating and finance leases. These disclosures allow analysts to evaluate the extent of off-balance sheet financing used by the company. They can also be used to detennine the effects on the financial statements if all the operating leases were capitalized and brought "onto" the balance sheet. See Table 2-6.

Under IFRS, companies are required to:

Present finance lease obligations as a part of debt on the balance sheet. Disclose the amount of total debt attributable to obligations under finance leases. Present information about all lease obligations (operating and finance leases).

© 2017Wiley

A comprehensive example discussing the financial statement presentation and disclosures relating to finance and operating leases is included in our practice questions.


Table 2-6: Summary of Financial Statement Impact of Leases on the Lessee and Lessor1

Lessee Balance Sheet

Operating Lease No effect

Income Statement

Reports rent expense


Rent payment is an operating cash outflow.

Finance Lease under IFRS Recognizes leased asset Reports depreciation Reduction of lease liability is a financing cash outflow. (capital lease under U.S. and lease liability expense on leased asset

GAAP)

Lessor

Operating Lease

Finance Lease3

When present value of lease payments equals the carrying amount of the leased asset (called a direct financing lease in U.S. GAAP)

When present value of lease payments exceeds the carrying amount of the leased asset (called a salestype lease in U.S. GAAP)

Reports interest expense on lease liability

Interest portion of lease payment is either an operating or financing cash outflow under IFRS and an operating cash outflow under U.S. GAAP.

Retains asset on balance Reports rent income sheet

Rent payments received are an operating cash inflow.

Removes asset from balance sheet

Recognizes lease receivable

Removes asset

Recognizes lease receivable

Reports depreciation expense on leased asset

Reports interest revenue on Interest portion of lease lease receivable payment received is either

an operating or investing cash inflow under IFRS and an operating cash inflow under U.S. GAAP.

Reports profit on sale

Receipt of lease principal is an investing cash inflow. b

Interest portion of lease payment received is either

Reports interest revenue on an operating or investing lease receivable cash inflow under IFRS and

an operating cash inflow under U.S. GAAP.

Receipt of lease principal is an investing cash inflow. b

1U.S. GAAP distinguishes between a direct financing lease and a sales-type lease, but IFRS does not. The accounting is the same for IFRS and U.S. GAAP despite this additional classification under U.S. GAAP.

bif providing leases is part of a company's normal business activity, the cash flows related to the leases are classified as operating cash.

I - Exhibit 2, Volume 3, CPA Program Curriculum 2017

©2017Wiley


LESSON 3: PENSIONS AND OTHER POST-EMPLOYMENT BENEFITS AND EVALUATING SOLVENCY

LOS 31j: Compare the presentation and disclosure of defined contribution and defined benefit pension plans. Vol 3, pp 624-627

Companies may offer a variety of benefits to their employees following their retirement. Examples of these benefits include pension plans, health care plans, and medical insurance. In this LOS, our focus is on pension plans. There are two main types of pension plans:

Defined-contribution plans are pension plans in which the company is required to contribute a certain (agreed-upon or defined) amount of funds into the plan. However, the company makes no commitment regarding the future value of plan assets. Further, investment decisions are left to employees, who bear all the investment risk. Since the company's annual contribution is defined and limited to the required contribution (i.e., the company has no further liability once the contribution has been made) accounting for defined-contribution plans is relatively straightforward.

On the income statement, the company recognizes the amount it is required to contribute into the plan as pension expense for the period. On the balance sheet, the company records a decrease in cash. If the agreed-upon amount is not deposited into the plan during a particular period, the outstanding amount is recognized as a liability. On the cash flow statement, the outflow is treated as an operating cash flow.

Under a defined-benefit plan, the company promises to pay future benefits to the employee during retirement. For example, a company could promise its employees an annual pension payment each year after her retirement until her death. The annual payment may be based on a formula that considers the final salary at retirement and the number of years of service provided by the employee to the company.

To illustrate, consider a company that determines an employee's annual pension benefit as 0.02 x Final salary at retirement x Number of years of service. A retiree who served the company for 20 years and had a final salary at retirement of $200,000 would, under the terms of this defined-benefit plan, be entitled to an annual pension payment of 0.02 x $200,000 x 20 ; $80,000 each year during her retirement until her death.

The company estimates the total amount of benefits that it expects to pay out to an employee during her retirement and then allocates the present value of these payments (this present values is known as pension obligation) over the employee's employment as a part of pension expense. A number of assumptions are made to determine the pension obligation, including:

Expected salary at date of retirement. Number of years the employee is expected to live after retirement. The discount rate (typically assumed to be the high-quality corporate bond yield).

Defined-benefit pension plans are typically funded through a separate legal entity (usually a pension trust fund). The company makes payments into the fund and invests these assets with a view to accumulating sufficient assets in the plan to meet payment obligations to retirees.

©2017Wiley

An important point that you must understand at this stageisthatforeach additional year of service provided by anemployee(asthe number of years of service increases) the annual retirement pension payment owed by the company to the employee would increase, resulting in an increase in the pension obligation (the present value oftotalpayments expected to be made to a retiree).


On the balance sheet, a company may record a net pension asset or a net pension liability.

If the fair value of plan assets is greater than the pension obligation (the present value of estimated payments to retirees) the plan has a surplus, so the company's balance sheet will reflect a net pension asset. If the fair value of plan assets is lower than the pension obligation the plan has a deficit, so the company's balance sheet will reflect a net pension liability.

On the income statement, the change in net pension liability or asset is recognized either in profit and loss or in other comprehensive income.

Under IFRS, the change in net pension asset or liability each period (pension expense) has three general components:

Employee service costs: The service cost during a period for an employee refers to the present value of the increase in pension benefit earned by the employee as a result of providing one more year of service to the company. Service costs also include past service costs (which reflect changes in the value of the pension obligation due to employees' service in past periods when a plan is initiated or when plan amendments are made). Employee service costs are recognized as pension expense in profit and loss. Net interest expense or income: This is calculated as the net pension liability or asset at the beginning of a period multiplied by the discount rate used to estimate the pension obligation (present value of expected pension payments). Net interest expense or income is also recognized as pension expense in profit and loss. Remeasurements: Remeasurements include (1) actuarial gains and losses and (2) the actual return on plan assets less any return included in net interest expense or income.

o Actuarial gains and losses arise when changes are made in any of the assumptions used to estimate the company's pension obligation (e.g. , mortality rates, life expectancy, rate of compensation increase, and retirement age).

o The actual return on plan assets (which are invested in a wide variety of asset classes including equity instruments) typically differs from the amount included in net interest expense or income (which is usually calculated based onjust the high-quality corporate bond yield).

Finally, note that remeasurements are not amortized into profit and loss over time; instead they are recognized in other comprehensive income.

Under U.S. GAAP, the change in the net pension asset or liability each period (pension expense) has five general components:

Employee service costs for the period: These are recognized in profit and loss in the period incurred. Interest expense accrued on the beginning pension obligation: Interest costs are added to pension expense because the company does not pay out service costs earned by the employee over the year until her retirement. The company owes these benefits to the employee, so interest accrues on the amount of benefits outstanding. Interest expense is also recognized in profit and loss for the period.

© 2017Wiley


Expected return on plan assets: This reduces the amount of pension expense recognized in profit and loss for the period. Past service costs: These are recognized in other comprehensive income in the period during which they are incurred, and are subsequently amortized into pension expense over the future service period of employees covered by the plan. Actuarial gains and losses: These are also recognized in other comprehensive income in the period in which they occur and amortized into pension expense over time.

Note that pension expense is not directly reported on the income statement: For employees directly related to the production process, pension expense is added to inventory and expensed through cost of goods sold (COGS). For employees not directly related to the production process, pension expense is included in selling, general & administrative (SG&A).

However, detailed pension plan-related disclosures are included in the notes to the financial statements (see Example 3-1).

Example 3-1: Pension Obligations

Jupiter Inc. reported the following disclosures related to retirement pension obligations in its 2011 annual report. The company follows IFRS.

($in Millions) 2011 2010 Retirement obligations Plan assets

2,980

1,055

2,510

985

I. Determine the pension-related amount that would be reported on Jupiter's balance sheet for the year 2011.

2. Indicate the amount of pension expense that would be recognized in 2011. Also describe how these expenses would be reported under the updated standards.

Solution

I. 2011 2010 $ $

Retirement Obligations 2,980 2,510

Plan Assets (1,055) (985)

Deficit/( surplus) 1,925 1,525

The positive funded status of $1,925 for 2011 indicates that the company' s pension plan is underfunded (retirement obligations exceed the value of assets that have been reserved for them). This is the amount that would be reported as a liability in Jupiter's 2011 balance sheet.

2. Total pension expense reported in 2011 would amount to $400 million, which equals the change in the pension deficit over the year.

Since the company follows IFRS, pension cost would be reported as follows:

©2017Wiley

Service costs and net interest expense (on the beginning pension deficit) would be reported in profit and loss. Remeasurements would be reported in other comprehensive income.

Effectively, U.S. GAAPaJlows companies to "smooth" the effects of past service costs and actuarial gains and losses on pension expense.


LOS 31k: Calculate and interpret leverage and coverage ratios. Vol 3, pp 627--029

Evaluating Solvency Ratios

Solvency refers to the ability of a company to satisfy its long-term debt obligation (both principal and interest payments). Ratio analysis is frequently used to evaluate a company's solvency levels relative to its competitors. The two main types of solvency ratios used are leverage ratios and coverage ratios.

Leverage ratios are derived from balance sheet numbers and measure the extent to which a company uses debt rather than equity to finance its assets. Higher leverage ratios indicate weaker solvency.

Coverage ratios focus more on income statement and cash flow numbers to measure the company's ability to service its debt. Higher coverage ratios indicate stronger solvency.

© 2017Wiley

Table 3-1 summarizes the two types of solvency ratios. See Example 3-2.

Table 3-1: Definitions of Commonly Used Solvency Ratios

Solvency Ratios

Leverage Ratios

Debt-to-assets ratio

Debt-to-capital ratio

Debt-to-equity ratio

Financial leverage ratio

Coverage Ratios

Interest coverage ratio

Fixed charge coverage ratio

©2017Wiley

Description

Expresses the percentage of total assets financed by debt

Measures the percentage of a company's total capital (debt+ equity) financed by debt.

Measures the amount of debt financing relative to equity financing

Measures the amount of total assets supported by one money unit of equity

Measures the number of times a company's EBIT could cover its interest payments

Measures the number of times a company's earnings (before interest, taxes and lease payments) can cover the company's interest and lease payments

Numerator

Total debt

Total debt

Total debt


EBIT

EBIT+ Lease payments


Denominator

Total assets

Total debt + Total shareholders' equity


Average shareholders' equity

Interest payments

Interest payments + Lease payments


Example 3-2: Evaluating Solvency Ratios

Given below are the solvency ratios for Mercury Inc. and Jupiter Inc. for 2008 and 2009:

Ratio Mercury Inc. Jupiter Inc.

2008 2009 2008 2009

Debt to assets 10.5% 9.4% 12.4% 4.9%

Debt to capital 13.6% 14.9% 25.8% 8.3%

Debt to equity 17.3% 18.5% 32.5% 9.8%

Interest coverage ratio 32.4 15.4 17.7 74.5

Use the information given in the table to answer the following questions:

I. A. Comment on the changes in the leverage ratios from year to year for both companies.

B. Comment on the leverage ratios of Mercury relative to Jupiter' s.

2. A. Comment on the changes in the interest coverage ratio from year to year for both companies.

B. Comment on the interest coverage ratio of Mercury Inc. compared to Jupiter Inc.

Solution

I. A. As shown in the table, Mercury's leverage ratios have remained fairly stable. On the other hand, Jupiter's leverage ratios have declined considerably from 2008 to 2009, which suggests that the company's solvency position is improving. The decrease in the company's leverage ratios may have resulted from a decrease in the company's debt and/or an increase in its equity.

B. In 2008, Mercury's leverage ratios were lower than those of Jupiter. However, the situation completely changed in 2009. This is because the capital structure of Mercury remained fairly constant over the 2 years, while Jupiter was able to bring down the proportion of debt in its capital structure significantly.

2. A. Mercury's interest coverage ratio decreased in 2009. This may be the result of a decrease in the company's operating earnings and/or an increase in its interest expense. On the other hand, Jupiter's interest coverage ratio increased in 2009, which may have been caused by an increase in the company's operating earnings and/or a decrease in its interest expense. Given that Jupiter's leverage ratios have declined significantly, it is more plausible that the increase in its interest coverage ratio is due to a decrease in its interest expense.

B. Based on the numbers for 2009, Jupiter has a greater ability to cover its interest payment obligations (based on its higher interest coverage ratio) compared to Mercury. However, the (relatively high) interest coverage ratios of both companies continue to suggest that they are comfortably placed to cover interest payments.

©2017Wiley

READING 32: FINANCIAL REPORTING QUALITY

LESSON 1: CONCEPTUAL OVERVIEW AND QUALITY SPECTRUM OF FINANCIAL REPORTS

LOS 32a: Distinguish between financial reporting quality and quality of reported results (including quality of earnings, cash flow, and balance sheet items). Vol 3, pp 64~44

Conceptual Overview

In this reading, we will talk about two interrelated attributes relating to the quality of a company 's financial statements: (!) financial reporting quality and (2) earnings quality.

Financial reporting quality refers to the usefulness of information contained in the financial reports, including disclosures in notes.

o High-quality reporting provides information that is useful in investment decision making in that it is relevant and faithfully represents the company's performance and position.

Earnings quality (or quality of reported results) pertains to the earnings and cash generated by the company's core economic activities and its resulting financial condition.

o High-quality earnings (I) come from activities that the company will be able to sustain in the future and (2) provide an adequate return on the company's investment.

o Note that the term, earnings quality, encompasses quality of earnings, cash flow, and balance sheet items.

These two attributes are interrelated because earnings quality cannot be evaluated until there is some assurance regarding the quality of financial reporting. If financial reporting quality is low, the information provided is not useful in evaluating company performance or to make investment decisions. Figure 1-1 illustrates this interrelationship and its implications.

Figure 1-1: Relationship between Financial Reporting Quality and Earnings Quality

Earnings (Results) Quality

©2017Wiley

High

Low

Financial Reporting Quality

Low High

LOW financial reporting quality impedes assessment of earnings quality and impedes valuation.

HIGH financial reporting quality enables assessment. HIGH earnings quality increases company value.

HIGH financial reporting quality enables assessment. LOW earnings quality decreases company value.

FINANCIAL REPORTING QUALITY


The concept of neutrality is one that we will be discussing in more detail later in the reading.

LOS 32b: Describe a spectrum for assessing financial reporting quality. Vol 3, pp 6~54

LOS 32c: Distinguish between conservative and aggressive accounting. Vol 3, pp 654-4j55

Quality Spectrum of Financial Reports

The two measures of quality can be combined such that the overall quality of financial reports from a user perspective can be thought of as spanning a continuum from the highest to the lowest (see Figure 1-2).

Figure 1-2: Quality Spectrum of Financial Reports

GAAP, decision-useful, sustainable, and adequate returns

GAAP, decision-useful, but sustainable? Low "earnings quality"

Within GAAP, but biased choices

Within GAAP, but "earnings management" (EM) -Rea.IEM -Accounting EM

Noncompliant Accounting

Fictitious transactions

We now describe each of the levels shown in the quality spectrum.

GAAP, Decision-Useful, Sustainable, and Adequate Returns

These are high-quality reports that provide useful information about high-quality earnings.

High-quality financial reports:

Conform to the accounting standards acceptable in the company's jurisdiction. Adhere to all the characteristics of decision-useful information, such as those defined in the Conceptual Framework. The fundamental characteristics of useful information are relevance and faithful representation.

o Relevant information is material and important for decision-making. o Faithful representation of information is complete, neutral, and free from error.

They also meet the enhancing characteristics of useful information as defined by the Conceptual Framework.

o These characteristics include comparability, verifiability, timeliness, and understandability.

High-quality earnings indicate an adequate return on investments. Further, earnings must be derived from activities that the company will likely be able to sustain in the

© 2017Wiley


future. Sustainable earnings that provide a high return on investment increase company value.

An adequate level of return means a return that exceeds the cost of investment and also meets (or even exceeds) the expected return. Sustainable activities and sustainable earnings are those that are expected to recur in the future.

GAAP, Decision-Useful, but Sustainable?

This level refers to a situation where high-quality reporting provides useful information, but the information reflects earnings that are not sustainable (low earnings quality). In other words, reporting is of high quality, but the economic reality being depicted is not of high quality. Earnings may be unsustainable because:

The company cannot expect to earn the same level of return on investment in the future (i.e., earnings are unsustainable). Earnings, though sustainable, will not generate a return on investment sufficient to sustain the company (i.e, the company is not earning enough).

Within GAAP, but Biased Accounting Choices

Biased choices result in financial reports that do not faithfully represent the company's true economic situation.

Management can make aggressive or conservative accounting choices, both of which go against the concept of neutrality, as unbiased financial reporting is the ideal. Investors may prefer conservative choices (as they result in positive surprises, which are easier to accept), but biased reporting (conservative or aggressive) adversely affects a user's ability to evaluate a company.

o Aggressive choices increase a company's reported financial performance and financial position in the current period. These choices can (I) increase reported revenues, (2) increase reported earnings, (3) increase reported operating cash flow, (4) decrease reported expenses, and/or (5) decrease reported debt in the current period.

Note that aggressive accounting choices in the current period may lead to depressed reported financial performance and financial position in later periods, thereby creating a sustainability issue.

o Conservative choices decrease a company's reported financial performance and financial position in the current period. These choices can (I) decrease reported revenues, (2) decrease reported earnings, (3) decrease reported operating cash flow, (4) increase reported expenses, and/or (5) increase reported debt in the current period.

Note that conservative accounting choices in the current period may lead to improved reported financial performance and financial position in later periods. Therefore, they do not give rise to a sustainability issue.

Another source of bias is understatement of earnings volatility (or earnings smoothing). This can result from employing conservative assumptions to understate performance when the company is actually doing well and then using aggressive assumptions when the company is not doing as well. Aside from biases in determining reported amounts, biases can also creep into the way information is presented. A company may choose to present information

©2017Wiley

Presentation choices are discussed in detail later in the reading.


in a manner that obscures unfavorable information and/or highlights favorable information.

o For example, emphasizing non-GAAP financial measures like pro forma earnings or non-GAAP operating profit to turn attention away from unfavorable financial results would be an aggressive presentation choice.

Poor reporting quality often comes with poor earnings quality, as aggressive accounting assumptions may be employed to obscure poor performance. However, it is also possible for poor reporting quality to come with high-quality earnings if:

The company is unable to produce high-quality reports due to inadequate internal controls. The company employs conservative accounting assumptions to make current performance look worse. A company may engage in such behavior to (I) avoid political attention or (2) keep some "hidden reserves," which it can tap into to improve future profitability.

Note that as we go down the spectrum the concepts of reporting quality and earnings quality become less distinguishable; it is necessary to have some degree of reporting quality in order to assess earnings quality.

Within GAAP, but ''Earnings Management"

Earnings management can be defined as "making intentional choices or taking deliberate action to influence reported earnings and their interpretation." The difference between making biased choices and earnings management is essentially intent. There are two ways that earnings can be managed:

They can be managed by taking real actions. o For example, a company may defer R&D expenses until the next year to

improve reported performance in the current year. They can be managed through accounting choices.

o For example, a company may change certain accounting estimates such as estimated product returns, bad debts expense, or asset impairment to manipulate reported performance.

Note that it is typically very difficult to determine intent, so there is a very fine line between earnings management and biased accounting choices.

Departures from GAAP-Noncompliant Accounting

Financial information that deviates from GAAP is obviously of low quality. Further, such financial information cannot be used to assess earnings quality, as comparisons with other entities or earlier periods cannot be made.

Examples of noncompliant accounting were found in the PP! (where currency losses suffered in the normal course of operations were reported directly through equity instead of through the P&L) and WorldCom (where a significant amount of operating expenses were capitalized to overstate profits) scandals.

©2017Wiley

Departures from GAAP-Fictitious Transactions

There have been instances of companies using fictitious transactions to (I) fraudulently obtain investments by inflating company performance, or (2) obscure fraudulent misappropriation of company assets.

Examples of such fraud can be found in the Equity Funding Corp (where fictitious revenues and even fictitious policyholders were created) and Parmalat (where fictitious bank balances were reported) scandals.

Differentiate between Conservative and Aggressive Accounting

When it comes to financial reporting, the ideal situation would be if financial reporting were unbiased (i.e., neither conservative nor aggressive). The common perception is that investors may prefer or are perceived to prefer conservative accounting because positive surprises are more acceptable than negative surprises, while management may prefer or is perceived to prefer aggressive accounting as it improves reported financial performance in the current period. However, when it comes to establishing expectations about the future, financial reporting that is relevant and faithfully representative is most useful.

Conservatism in Accounting Standards

The Conceptual Framework supports the neutrality of information (i.e., an unbiased selection and presentation of financial information). Conservatism directly conflicts with the concept of neutrality as it leads to biased estimates of assets, liabilities, and earnings. Despite efforts to encourage neutrality in financial reporting, some conservatively biased standards remain.

An example can be found in the oil-and-gas exploration industry, where recognition of revenues generally requires a higher level of verification than recognition of expenses. In this industry, the "good news" event is the discovery of new oil and gas reserves, which can be tapped into in future years to generate profits. Unfortunately, however, one would not learn about this fact from simply looking at a company's financials because accounting standards dictate that revenue can only be recognized once the resources have been extracted, a customer has been identified, and the product has been shipped. As a result, recognition of revenues from new oil and gas reserves is deferred until several years after their initial discovery. Further, accounting standards also require extraction costs to be expensed rather than capitalized, which leads to reduced profits in periods between discovery and first sales from new reserves despite the fact that these reserves possess saleable value.

The previous example illustrates how conservatism in accounting standards (which leads to a delay in recognition of profits until they are highly verifiable) can impair the relevance of financial statements. Note that many jurisdictions, in order to mitigate this issue, now require extensive disclosures from such companies.


Finally, note that different sets of accounting standards may have different degrees of conservatism embedded in them. For example, when it comes to long-lived assets, IFRS recognizes impairment when the recoverable amount (fair value) is less than the carrying amount, while U.S. GAAP recognizes impairment if the sum of undiscounted future cash flows from the asset is less than the carrying amount. If the recoverable amount were less than the sum of undiscounted cash flows, an impairment charge would be more likely under IFRS, making it relatively more conservative. Note that IFRS does allow reversals of impairment charges, while U.S. GAAP does not.

©2017Wiley


Other examples of conservatism in accounting standards include research costs, litigation costs, insurance recoverables, and commodity inventories.

Benefits of Conservatism Given asymmetrical information, conservatism may protect contracting parties with less information and higher risk.

o For example, shareholders enjoy limited liability so bond investors have limited recourse to individual shareholders to recover losses from default. Financial statements prepared with conservative assumptions may leave room for a "cushion" to protect bond holders.

Conservatism reduces the possibility of litigation. A company is highly unlikely to be sued if it understated good news/overstated bad news. Conservatism protects politicians and lawmakers, as it reduces the possibility that companies under their supervision have overstated earnings or assets. In many jurisdictions, companies can lower the present value of their tax payments by employing conservative accounting policies.

Bias in the Application of Accounting Standards

The application of any accounting standard (regardless of whether it is inherently neutral) requires significant amounts of judgment. In order to characterize the application of an accounting standard as conservative or aggressive, we must look at intent (rather than at a definition). Intent can be inferred from a careful analysis of disclosures, facts, and circumstances. Examples of biased accounting disguised as conservatism include:

Big bath behavior: This refers to the strategy of manipulating a company's income statement to make poor results look even worse. The big bath is often implemented in a bad year with a view to inflating subsequent period earnings. New management teams sometime use the big bath so that poor current performance can be blamed on previous management, while they take credit for the impressive growth that follows in subsequent periods. Cookie jar reserve accounting: This refers to the practice of creating a liability when a company incurs an expense that cannot be directly linked to a specific accounting period. Companies may recognize such expenses in periods during which profits are high, as they can afford to take the hit to income, with a view to reducing the liability (the reserve) in future periods during which the company may struggle. The practice results in smoothing of income over time.

LESSON 2: CONTEXT FOR ASSESSING FINANCIAL REPORTING QUALITY

LOS 32d: Describe motivations that might cause management to issue financial reports that are not high quality. Vol 3, pp 655-4;58

CONTEXT FOR ASSESSING FINANCIAL REPORTING QUALITY

In assessing financial reporting quality, it is important to consider (1) whether a company's management may be motivated to issue financial reports that are not of high quality, and (2) whether the reporting environment is conducive to misreporting.

© 2017Wiley


Motivations

Management may issue financial reports that are not of high quality:

To mask poor performance, such as loss of market share or lower profitability than other companies in the industry. To meet or beat analysts ' forecasts or management's own forecasts. Exceeding forecasts typically increases the company's stock price (at least for the short term) and can increase management compensation if it is linked to company and/or stock price performance. Motivations to meet earnings expectations can be classified as:

o Equity market effects, which refer to management trying to build credibility with market participants and to positively impact the company's stock price.

o Trade effects, which refer to management trying to improve the company 's reputation with customers and suppliers. Trade effects are particularly important for small companies.

To address managers ' concerns regarding their careers. Managers may be concerned that working for a company that is struggling would affect their future career opportunities adversely. Surveys of managers that have exercised accounting discretion to achieve desirable earnings goals have actually found that managers tend to be more concerned about career implications of reported results than with incentive compensation implications. To avoid debt covenant violations. Managers of highly leveraged unprofitable companies can be motivated to inflate earnings to get around debt covenant violations.

LOS 32e: Describe conditions that are conducive to issuing low-quality, or even fraudulent, financial reports. Vol 3, pg 657

Conditions Conducive to Issuing Low-Quality Financial Reports

Generally speaking, the following three conditions exist when low-quality financial reports are issued:

Opportunity: Poor internal controls, an ineffective board of directors, or accounting standards that allow divergent choices and/or provide minimal consequences for inappropriate choices can give rise to opportunities for management to issue lowquality financial reports. Motivation: Motivation to issue low-quality financial reports can come from personal reasons (e.g. , increasing bonus payments) or corporate reasons (e.g., alleviating concerns about being able to raise funds in the future). Rationalization: This is important because individuals need to justify their choices to themselves.

LOS 32f: Describe mechanisms that discipline financial reporting quality and the potential limitations of those mechanisms. Vol 3, pp 659-666

Mechanisms that Discipline Financial Reporting Quality

Markets: Companies compete for capital, and the cost of capital is directly related to the level of perceived risk (including the risk that a company's financial statements will be

©2017Wiley


misleading). In the absence of any other conflicting incentives, companies should aim to provide high-quality financial reports to minimize their long-term cost of capital.

Regulatory authorities: Market regulators establish and enforce rules. They directly affect financial reporting quality through:

Registration requirements: Companies that plan to issue securities must register them with market regulators before offering them to the public. Registration documents must include current financial statements, relevant information about the risks and prospects of the issuing company, and information regarding the securities being offered. Disclosure requirements: Publicly traded companies are required to make periodic financial reports (with management comments) available to the public. Auditing requirements: Financial statements must be accompanied by an audit opinion certifying that presented financials conform to relevant accounting standards. Management commentaries: Financial reports issued by publicly traded companies must include statements by management including a review of the company 's business and description of principal risks and uncertainties facing the company. Responsibility statements: Person(s) responsible for the company's filings are required to explicitly acknowledge responsibility and to attest to the correctness of financial reports. Regulatory review of filings: Regulators usually undertake a review process to ensure that companies have followed all rules. Enforcement mechanisms: Regulators are granted various powers to enforce securities market rules. Examples of these powers include assessing fines, suspending or permanently barring companies, and bringing criminal prosecution against companies.

Auditors

While public companies are required to have their financial statements audited by an independent auditor, private companies also obtain audit opinions regarding their financial statements, either voluntarily or to meet requirements imposed by providers of capital.

Limitations of audit opinions An audit opinion is based on information prepared by the company, so if a company deliberately intends to deceive its auditor, a review of provided information might not uncover misstatements. An audit is based on a sample of information, and the sample might not reveal any misstatements. An "expectations gap" may exist between the auditor's actual role and what the public perceives the auditor's role to be. Typically, the aim of an audit is not to look for fraud; it is to verify that financial reports are fairly presented. Audit fees are often established through a competitive process, and the company being audited bears the cost of the audit (audit fees). As a result, the auditing company may show leniency toward the company being audited, particularly if it provides additional services to the company.

© 2017Wiley

Private Contracting

Parties that have a contractual agreement with a company have an incentive to monitor the company's performance and to ensure that financial reports are of high quality. For example, consider the following provisions:

Loan agreements contain covenants that, if violated, can result in a technical default of the borrower. Certain investment contracts contain provisions that enable the investor to recover all or part of its investment if certain financial triggers occur.

Such provisions can motivate borrowers/investees to manipulate reported results to avoid unfavorable repercussions, and this possibility for misreporting in turn motivates lenders/ investors to monitor financial reports and ensure that they are of high quality.

LESSON 3: DETECTION OF FINANCIAL REPORTING QUALITY ISSUES

LOS 32g: Describe presentation choices, including non-GAAP measures, that could be used to influence an analyst's opinion. Vol 3, pp 661H;71

Detection of Financial Reporting Quality Issues


Presentation Choices

During the technology boom of the 1990s and the internet bubble of the early 2000s there were companies that were trading at extremely high PIE ratios, and the earnings they were generating could not justify their (extremely high) stock prices. As a result, many market participants tried to justify these valuations based on new metrics such as "eyeballs captured" or the "stickiness" of websites. Further, various versions of "proforma earnings" or "non-GAAP earnings measures" were commonly reported during those times.

Pro forma reporting was also employed by several established companies in the early 1990s. For example, IBM reported massive restructuring charges in 1991 ($3.7 billion), 1992 ($11.6 billion), and 1993 ($8.9 billion) as it moved its focus from mainframe computers to personal computers; Sears incurred restructuring charges worth $2.7 billion in 1993; andAT&T reported restructuring charges of $7.7 billion in 1995. Further, restructuring charges were quite the norm during those times. Companies were keen to avoid giving the impression that they were struggling, so under the pretext of assisting investors in evaluating operating performance, they would conveniently exclude restructuring charges in pro forma measures of financial performance.

Reporting of pro forma earnings was also facilitated by the accounting principles that applied for reporting business combinations. Before 2001, there were two methods for accounting for acquisitions: (I) the pooling-of-interests method, which is no longer permitted, and (2) the purchase method.

While it was fairly difficult to qualify for using the pooling-of-interests method, it was greatly desired because it did not result in goodwill amortization charges going forward. On the other hand, the purchase method entailed significant goodwill amortization charges (potentially over a 40-year period), resulting in lower earnings over an extended period.

©2017Wiley


Companies that were making acquisitions aggressively and using the purchase method felt that they were at a reporting disadvantage compared with companies that were able to apply pooling-of-interests accounting. Therefore, these companies began to present earnings excluding amortization of intangible assets and goodwill.

EBITDA (earnings before interest, taxes, depreciation, and amortization) has been widely used by investors to make comparisons across companies on a consistent basis, as it eliminates the impact of the different accounting methods that companies may use for depreciation, amortization of intangible assets, and restructuring charges. As a result of the popularity of this measure, companies have come up with their own definitions of EBITDA (sometimes referring to it as adjusted EBITDA) by conveniently excluding more items from net income. Some of the items that tend to be excluded to manipulate reported performance are:

Rental payments for operating leases, resulting in EBITDAR (earnings before interest, taxes, depreciation, amortization, and rentals). Equity-based compensation. Exclusion of this (normal operating expense) is usually justified on the grounds that it is a noncash expense. Acquisition-related charges. Impairment charges for goodwill or other intangible assets. Impairment charges for long-lived assets. Litigation costs. Loss/gain on debt extinguishments.

There is a general concern that companies may use non-GAAP measures to distract users from GAAP measures. U.S. GAAP and IFRS have both moved to pacify these concerns. For example, under U.S. GAAP, if a company uses a non-GAAP financial measure in an SEC filing, it must (I) display the most directly comparable GAAP measure with equal prominence, (2) provide a reconciliation of the non-GAAP measure and the equivalent GAAP measure, and (3) explain why it believes that the non-GAAP financial measure provides useful information regarding the company's financial condition and operations. IFRS places similar requirements on companies. Example 3-1 describes a case of misuse and misreporting of non-GAAP measures.

Example 3-1: Misuse and Misreporting of Non-GAAP Measures

Groupon is an online discount merchant. In the company's initial S-1 registration statement in 2011, its CEO said that the company did not measure itself "in conventional ways." He described Groupon's adjusted consolidated segment operating income (adjusted CSOI) measures (see Exhibit 3-1). The company also provided a reconciliation of CSOJ to the most comparable U.S. GAAP measure (see Exhibit 3-2).

In its review, the SEC took the position that online marketing expenses were a recurring cost of business. Groupon responded that the marketing costs were similar to acquisition costs, not recurring costs, and that it would ramp down marketing just as fast as it ramped it up, reducing the customer acquisition part of its marketing expenses over time.

Eventually, and after much negative publicity, Groupon changed its non-GAAP measure (see Exhibit 3-3).

©2017Wiley

Exhibit 3-1: Groupon's "Non-GAAP Financial Measures"

Disclosures from June S-1 Filing

Adjusted CSOI is operating income of our two segments, North America and International, adjusted for online marketing expense, acquisition-related costs and stock-based compensation expense. Online marketing expense primarily represents the cost to acquire new subscribers and is dictated by the amount of growth we wish to pursue. Acquisition-related costs are nonrecurring noncash items related to certain of our acquisitions. Stock-based compensation expense is a noncash item. We consider Adjusted CSOI to be an important measure of the performance of our business as it excludes expenses that are noncash or otherwise not indicative of future operating expenses. We believe it is important to view Adjusted CSOI as a complement to our entire consolidated statements of operations.

Our use of Adjusted CSOI has limitations as an analytical tool, and you should not consider this measure in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:

Adjusted CSOI does not reflect the significant cash investments that we currently are making to acquire new subscribers. Adjusted CSOI does not reflect the potentially dilutive impact of issuing equitybased compensation to our management team and employees or in connection with acquisitions. Adjusted CSOI does not reflect any interest expense or the cash requirements necessary to service interest or principal payments on any indebtedness that we may incur. Adjusted CSOI does not reflect any foreign exchange gains and losses. Adjusted CSOI does not reflect any tax payments that we might make, which would represent a reduction in cash available to us. Adjusted CSOI does not reflect changes in, or cash requirements for, our working capital needs. Other companies, including companies in our industry, may calculate Adjusted CSOI differently or may use other financial measures to evaluate their profitability, which reduces the usefulness of it as a comparative measure.

Because of these limitations, Adjusted CSOI should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. When evaluating our performance, you should consider Adjusted CSOI alongside other financial performance measures, including various cash flow metrics, net loss and our other GAAP results.

Exhibit 3-2: Groupon's "Adjusted CSOI"

Excerpt from June S-1 Filing

The following is a reconciliation of CSOI to the most comparable U.S. GAAP measure, "loss from operations," for the years ended December 31 , 2008, 2009, and 2010 and the three months ended March 31, 20 IO and 20 II :

©2017Wiley



Three Months Year Ended December 31 Ended March 31

(in$'000) 2008 2009 2010 2010 2011

Loss (income from (1 ,632) (1 ,077) (420,344) 8,571 (117,148) operations)

Adjustments:

Online marketing 162 4,446 241 ,546 179,903

Stock-based 24 115 36,168 18,864 compensation Acquisition-related 203,183

Total adjustments 186 4,561 480,897 198,767

Adjusted CSOI (1,446) 3,484 60,533 81,619

Exhibit 3-3: Groupon's CSOI

Excerpt from Revised S-1 Filing

The following is a reconciliation of CSOI to the most comparable U.S. GAAP measure, "loss from operations," forthe years ended December 31 , 2008, 2009, and 2010 and the nine months ended September 30, 2010 and 2011:

Nine Months Ended Year Ended December 31 September 30

(in$'000) 2008 2009 2010 2010 2011

Loss (income from (1 ,632) (1,077) (420,344) 84,215 (218,414) operations)

Adjustments:

Stock-based 24 115 36,168 8,739 60,922 compensation Acquisition-related 203,183 37,844 (4,793)

Total adjustments 24 115 239,351 46,583 56,129

Adjusted CSOI (1,608) (962) (180,993) (37,632) (162,285)

Answer the following questions:

I. What cautions did Groupon include along with its description of the "Adjusted CSOI" metric?

2. Groupon excludes "online marketing" from "Adjusted CSOI." How does the exclusion of this expense compare with the SEC's limits on non-GAAP performance measures?

3. In the first quarter of 2011 , what was the effect of excluding online marketing expenses on the calculation of "Adjusted CSOI"?

4. For 2010, how did results under the revised non-GAAP metric compare with the originally reported metric?

~ © 2017Wiley


Solution:

I. Groupon warned that the "adjusted CSOI" metric should not be used in isolation, it should not be used as a substitute for GAAP results in conducting analysis, and it should not be used as a measure of discretionary cash available to the company to invest in growth.

2. The SEC asserts that online marketing expenses were a recurring cost of business (they appear in every period reported and are likely to be incurred going forward). Exclusion of this item from reported adjusted CSOI goes against SEC requirements.

3. The exclusion of online marketing expenses amounting to $179,903 resulted in adjusted CSOI being inflated. In fact, the amount was significant enough to swing the company from a loss to a profit and it enabled the company to show results that 35% higher for the quarter (adjusted CSOI = $81,619) compared to the whole of 2010 (adjusted CSOI = $60,553).

4. Groupon's revised CSOI for 2010 shows a negative CSOI of $180,993 compared to a positive adjusted CSOI of $60,553 . Online marketing expenses are included in the revised measure, in line with SEC requirements.

LOS 32h: Describe accounting methods (choices and estimates) that could be used to manage earnings, cash flow, and balance sheet items. Vol 3, pp 672-689

Accounting Choices and Estimates

In the text that follows, we highlight areas where accounting choices and estimates have an impact on how various accounting elements (assets, liabilities, owners' equity, revenues, and expenses) are recognized, measured, and reported. In the LOS that follows, we provide guidance regarding what investors and analysts must do to find warning signs.

Revenue Recognition Does the company recognize revenue upon shipment (referred to as FOB shipping point) or upon delivery (referred to as FOB destination) of goods? Under the former, revenue (and associated profit) is recognized upon dispatch of goods, while under the latter, revenue (and associated profit) is recognized later when goods reach the customer.

©2017Wiley

o Sometimes management may be pushing shipments out the door (known as channel stuffing) under FOB shipping point arrangements. A company may engage in such a practice to maximize revenue recognized in the current accounting period. The company can push sales toward the end of the accounting period by inducing customers to buy more through unusual discounts, threatening to increase prices in the near term, or even shipping goods that were not actually ordered in the hope that customers would keep them (at worst, customers would return them, but those returns would not be recognized until the next period).

If the ratio of accounts receivable to revenues is abnormally high relative to the company's history or its peers, there is a chance that channel stuffing has occurred.

o At other times, for shipments toward the end of the reporting period, management may set shipping terms as FOB destination. Management may


engage in this practice if there was an overabundance of orders during the current period, and it does not want investors/analysts to get too optimistic.

A company can reduce its allowance for sales returns as a proportion of sales to reduce expenses and increase profits. A downward revision in the noncollection rate can easily be justified on grounds such as improvement in the economic prospects of clients. The point is that whatever the justification, it would be difficult to prove whether it is right or wrong until significant time has passed. Since proof of reliability of estimates is not available at the time an estimate is made/changed, managers have a readily available means of manipulating earnings at their discretion.

o Analysts should examine whether the company 's actual collection experience has tended to be different from historical provisioning in order to assess the accuracy of the company's provisioning policies.

If a company participates in "bill-and-hold" transactions (where a customer purchases goods but requests that the goods remain with the seller until a later date), it is possible that it is recognizing fictitious sales by reclassifying end-ofperiod inventory as "sold but held" through minimal effort and fake documentation (i.e. , simply reclassifying inventory as "bill-and-hold" sales). If the company uses rebates as part of its marketing approach, changes in estimates of rebate fulfillment can be used to manipulate reported revenues and profitability (similar to allowance for sales returns). If the company separates its revenue arrangements into multiple deliverables of goods or services, investors should look out for any changes in the allocation of revenue across the deliverables.

o For example, consider a company that sells hardware devices and includes a free two-year service contract in the selling price. The company allocates a portion of revenues to the hardware device (which is recognized immediately upon sale) and a portion to the service contract (which it recognizes over the two-year period following the sale). In order to inflate reported revenue and profits, the company could allocate a higher (than historical) percentage of revenue to hardware.

o This area provides management with great revenue recognition flexibility, while providing very little visibility to investors. In order to pacify any concerns regarding financial reporting manipulation, investors should ask the following questions:

Does the company adequately disclose how revenue is allocated across deliverables and how revenue is recognized on each one? If a certain portion of revenue is recognized over time (as in the previous example) do the financial statements show deferred revenues? Are there unusual trends in revenues and receivables, especially relating to cash conversion?

Depreciation Policies Regarding Long-Lived Assets Companies can use changes in depreciation estimates (useful life and salvage value) and depreciation methods to manipulate reported earnings and profits. As was the case with estimates relating to sales returns, choices and estimates relating to depreciation are not proven right or wrong until far into the future, while they can be manipulated to have an immediate impact on earnings. If the company has recorded significant asset write-downs in the recent past, it may suggest that the company's policies relating to asset lives need to be examined.

© 2017Wiley

Capitalization Policies Relating to Intangibles In classifying a payment made, management must determine whether the payment will benefit the company only in the current period (making it an expense) or whether it will benefit the company in future periods (in which case it should be capitalized as an asset). Management may try to capitalize costs that ought to be recorded as expenses to increase reported income (as was the case with WorldCom). In accounting for an acquisition, the purchase price must be allocated to different assets acquired based on their fair values. These fair values are not always objectively verifiable. Management may use low fair-value estimates in order to depress future depreciation expense and inflate future profitability. Further, any excess of the purchase price over the fair value of assets acquired must be classified as goodwill, which is neither depreciated nor amortized in future periods. A higher allocation to goodwill will improve reported financial performance going forward. Goodwill reporting brings further avenues for manipulation. Since it is neither depreciated nor amortized, companies must determine whether goodwill (i.e. , the excess of the purchase price over the fair value of assets) is recoverable. If it is not, goodwill must be written-down. In order to determine the fair value of goodwill, forecasts of future financial performance must be made, and these projections may be biased upward to avoid a goodwill write-down. Analysts should also examine how the company's capitalization policies compare with the competition and determine whether its amortization policies are reasonable.

Inventory Cost Methods

As we learned in the reading on inventories, the inventory cost flow assumption chosen by management affects the income statement and the balance sheet. In a period of rising prices and stable or increasing inventory quantities:

LIFO COGS is greater than FIFO COGS, which results in greater profitability under FIFO. FIFO EI is greater than LIFO EI, which results in greater liquidity/solvency under FIFO. Note that regardless of the trend in prices:

o FIFO provides a more current picture of ending inventory value, so the balance sheet is more relevant under FIFO.

o LIFO captures replacement costs more accurately in COGS, so the income statement is more relevant under LIFO.

Analysts should determine how a company's inventory methods compare with others in its industry. If the company uses reserves for obsolescence in its inventory valuation, unusual fluctuations in this reserve might suggest that the company is manipulating them to attain a desired level of earnings. If a company uses LIFO in an inflationary environment, it can temporarily increase reported profits through LIFO liquidation (where sales exceed purchases over the period, enabling the company to dip into old units of stock carried at old, lower prices, thereby deflating COGS).

©2017Wiley



Deferred Tax Assets and Valuation Accounts

As we learned in the reading on taxes, a company that incurs losses can carry those losses forward to reduce taxable income in the future, thereby reducing its tax liability in the future. In order to recognize these deferred tax assets, there must be an expectation that the company will generate enough taxable income in the future. Otherwise the value of these tax assets must be reduced through a contra asset account known as the valuation allowance.

Analysts must evaluate whether the company's estimate of the valuation allowance is reasonable given its current operating environment and future prospects. Specifically they should:

o Determine whether there are contradictions between the management commentary and the allowance level, or the tax note and the allowance level. For example, there cannot be an optimistic management commentary and a fully reserved tax asset (zero tax asset net of the valuation allowance), or vice versa.

o Look for changes in the tax asset valuation account. It may be 100% reserved at first, and then management may become more "optimistic" whenever an earnings boost is needed. Recall that an increase in deferred tax assets (lowering the valuation allowance) decreases income tax expense and increases net income.

Warranty Reserves

Analysts should examine whether these reserves have been manipulated to meet earnings targets. Further, the trend in actual costs relative to amounts allocated to reserves should be assessed, as it can offer insight into the quality of products sold.

Related Party Transactions

If the company engages in extensive dealings with nonpublic companies that are under management control, the nonpublic companies could be used to absorb losses (e.g., through supply arrangements that are unfavorable to the nonpublic company) in order to improve the public company's reported performance.

Choices that Affect the Cash Flow Statement

Many investors scrutinize the operating section of the cash flow statement in detail, as they believe that operating cash flow serves as a reality check on earnings; significant earnings that can be attributed to accrual accounting and are unsupported by actual cash generation may indicate earnings manipulation. Even though the operating section of the cash flow statement is more insulated from management manipulation than the income statement, it can still be managed in the following ways:

Stretching out payables: Management may try to delay payments to creditors until after the balance sheet date so that the increase in accounts payable over the period (source of cash) results in an increase in cash generated from operations. In order to detect this issue, analysts could:

Examine changes in working capital to look for unusual patterns that may indicate manipulation of cash provided from operations.

©2017Wiley


Compare the company's cash generation with the cash operating performance of its competitors. Compare the relationship between cash generated from operations and net income. Analysts should be concerned if cash generated from operations is less than net income, as it may suggest that accounting estimates are being used to inflate net income.

Misclassifying cash flows : A company may ntisclassify uses of operating cash flow into the investing or financing section of the cash flow statement to inflate cash generated from operating activities.

Taking advantage of flexibility in cash flow statement reporting In certain areas where investors may not even be aware that choices exist (e.g. , amortization of discount/prentium on capitalized interest), accounting standards offer companies the flexibility to manage cash generated from operations to a certain extent. Certain jurisdictions offer significant flexibility in classification of certain cash flows. For example, under IFRS:

o Interest paid can be classified as operating or financing cash flow. o Interest and dividends received may be classified as operating or investing

cash flow. o Dividends paid may be classified as operating or financing cash flow.

LOS 32i: Describe accounting warning signs and methods for detecting manipulation of information in financial reports. Vol 3, pp 68~94

Warning Signs

Warning Signs Related to Revenue

Analysts should:

Deterntine whether company policies make it easy to prematurely recognize revenue by allowing use of FOB shipping point shipping terms and bill-and-hold arrangements. Determine whether a significant portion of revenues comes from barter transactions (which are difficult to value properly). Evaluate the impact of estimates relating to the company's rebate programs on revenue recognition. Look for sufficient clarity regarding revenue recognition practices relating to each item or service delivered under multiple-deliverable arrangements of goods and services. Determine whether the company's revenue growth is in line with its competitors, its industry, and the overall economy. Deterntine whether receivables are increasing as a percentage of sales. This may suggest channel-stuffing activities or even recognition of fictitious sales. Deterntine whether there are any unusual changes in the trend in receivables turnover and seek an explanation for any changes. Compare the company's receivables turnover (or DSO) with competitors, and look out for suggestions that revenues have been recognized prematurely or that the provision for doubtful accounts is insufficient.

©2017Wiley


Examine asset turnover. o If post-acquisition revenue generation is weak, management may try to

play with estimates to increase reported revenue in order to be able to justify their strategic choices.

o If asset turnover is trending lower, or if it lags the asset turnover of competitors, it may signal future asset write-downs by the company.

Warning Signs Related to Inventories

Analysts should:

Compare growth in inventories with competitors and industry benchmarks. o If inventory levels are increasing with no accompanying increase in

sales it could suggest (I) poor inventory management or (2) inventory obsolescence. In case of the latter, current profitability and inventory value would be overstated.

Compute the inventory turnover ratio. o Declining inventory turnover could also suggest inventory obsolescence.

Check for inflated profits through LIFO liquidations (only applicable for firms using LIFO).

Warning Signs Related to Capitalization Policies and Deferred Costs

Analysts should examine the company's accounting policy notes for its capitalization policy for long-term assets (including interest costs) and for its handling of other deferred costs, and compare those policies with industry practice. If the company is the only one capitalizing certain costs while other industry participants expense them, a red flag is raised.

Warning Signs Related to the Relationship between Cash Flow and Income

If a company's net income is persistently higher than cash provided by operations, it raises the possibility that aggressive accrual accounting policies have been used to shift current expenses to later periods. Analysts may construct a time series of cash generated by operations divided by net income. If the ratio is consistently below 1.0, or has declined consistently, there may be problems in the company 's accrual accounts.

Other Potential Warning Signs

Depreciation methods and useful lives: As discussed earlier, the choice of depreciation methods, useful lives, and salvage values of long-lived assets can have a significant impact on reported profitability. Analysts should compare a company's policies with those of its competitors to detennine whether they are significantly different.

Fourth-quarter surprises: Analysts should suspect possible earnings management if a company's earnings routinely disappoint in the first three quarters of the reporting period and then spring a positive surprise in the fourth quarter, if the business is not seasonal.

Presence of related-party transactions: Related-party transactions are often an issue when company founders are still involved in its day-to-day running, and have their own wealth and reputations tied to the company's performance. For example, they may (through

© 2017Wiley


another company of their own) purchase unsellable inventory from the company in order to avoid write-downs.

Nonoperating income and one-time sales included in revenue: A company may engage in such behavior to cover weak revenue growth, or to boost reported revenue growth. If undetected, analysts would overestimate the sustainability of company revenues.

Classification of an expense as nonrecurring: This would inflate reported operating profits. If the same "special items" are classified as nonrecurring by the company year after year, analysts would be better off focusing on net income rather than operating profit.

Gross/operating margins out of line with competitors or industry: While this could signal superior management performance, it may also indicate the presence of accounting manipulation. The point is that it is a sign that further analysis is required.

Younger companies with an unblemished record of meeting growth projections: While it is completely possible for a young company with popular products to generate impressive returns for a period of time, analysts should keep in mind that as the industry matures, the company may be tempted to extend its record of rapid growth in sales and profitability by using aggressive estimates, drawing down cookie jar reserves, selling assets for accounting gains, or window-dressing financial statements.

Management has adopted a minimalist approach to disclosure: Analysts should be concerned when large companies only have one reportable segment, or when management commentary is similar from period to period. While a plausible explanation for providing minimal guidance could be protecting investor interests by keeping information from competitors, this may not necessarily be the case.

Management fixation on earnings reports: Analysts should be wary of companies whose management is obsessed with reported earnings, as this may be to the detriment of real drivers of value. Fixation with earnings could be indicated by:

Aggressive use of non-GAAP measures of performance, special items, or nonrecurring charges. Decentralized operations where management compensation is heavily tied to reported earnings or non-GAAP performance measures.

Other factors that analysts should consider include:

The company's culture: Management with a highly competitive mentality would serve investor interest well when it comes to conducting business (as long as it does not take actions that are illegal or unethical), but analysts should assess whether such a mind-set also exists when it comes to preparing financial statements. A predisposition to manage earnings is more likely to exist when:

The CEO also serves as the board chair. The audit committee of the board lacks financial reporting sophistication and is subservient to the CEO. When the CEO is not penalized (and instead may even be rewarded) for exercising financial reporting discretion to artificially smoothen earnings.

©2017Wiley


Restructuring and/or impairment charges: At times, it has been observed that a company's stock price rises upon recognition of a "big bath" charge against current income. The rationale is that management has identified and parted with underperforming portions of the company, and has shifted its attention to more profitable activities. Analysts, however, should appreciate that the restructuring charge suggests that expenses reported over prior years were probably understated (even if no financial statement manipulation occurred) and therefore make appropriate (downward) adjustments to prior years' earnings.

Management has a merger and acquisition orientation: Consider Tyco International Ltd., a company that acquired 700 companies in the period 1996-2002. The SEC found that Tyco was consistently fraudulently understating assets acquired in order to lower future depreciation and amortization charges, and overstating liabilities assumed. The point is that a growth-at-any-cost strategy can create issues when it comes to operational and financial controls.

Note that these warning signs are signals, not declarations of accounting manipulation. They should be evaluated cohesively, not on an isolated basis. If an analyst finds several warning signs, the particular investment should be viewed with skepticism and perhaps discarded in favor of other alternatives.

© 2017Wiley

FINANCIAL STATEMENT ANALYSIS: APPLICATIONS

READING 33: FINANCIAL STATEMENT ANALYSIS: APPLICATIONS

LESSON 1: EVALUATING PAST FINANCIAL PERFORMANCE AND PROJECTING FUTURE PERFORMANCE

LOS 33a: Evaluate a company's past financial performance and explain how a company's strategy is reflected in past financial performance. Vol 3, pp 705-713

An analysis of a company's past performance should address what happened (how well the company performed over the period) and also why it happened (the reasons behind its performance). Analysis should focus on:

Important changes that have occurred in corporate measures of profitability, efficiency, liquidity, and solvency and the reasons behind these changes. Comparisons of the company's financial ratios with others from the same industry and the reasons behind any differences. Examination of performance aspects that are critical for a company to successfully compete in the industry and an evaluation of the company's performance on these fronts relative to its competitors'. The company's business model and strategy and how they influence its operating performance.

A company's strategy is usually reflected in its financial statements. Some examples of different strategies across companies and how we might expect their financials to differ are given below:

Low cost airlines like Southwest® focus on generating profits through high volumes with low margins. Others, like Silverjet® (an exclusively business class airline) cater to high-end customers only. While Silverjet 's sales volume (in units) would be significantly lower than Southwest's, Silverjet's gross margin should be higher as it offers a premium service.

McDonald's® initially concentrated on building its business within U.S. borders. Over recent years, it has focused more on increasing sales outside the United States. This strategy is reflected in McDonald's financial statements, in the form of a higher sensitivity of total profits to changes in the value of the dollar. For example, foreign-exchange gains helped boost McDonald's profitability in early 2008 (when the dollar depreciated against most currencies) as a significant portion of revenues came from its international (non-U.S.) operations.

The bigger, well-known pharmaceutical companies in the developed world (e.g. , Glaxo Smith Kline® and Sanofi Aventis®) devote significant amounts of money to R&D to come up with vaccinations and medications to tackle various illnesses more effectively. They invest so much in R&D because they are able to obtain patents for their products, which protect them from competition from imitators and allows them to set prices high enough to generate profits. Other companies (e.g., Dr. Reddy 's Laboratories®) focus on simply producing generic drugs whose patent-protection periods have expired. The ASP (average

©2017Wiley


selling price) of Dr. Reddy's products is lower than that of its Western counterparts, but it relies on high volumes to generate profits.

In the year 2004, Motorola® revamped its cellular phone business and came out with a revolutionary thin cell phone called the Razr®. Motorola' s heavy investment in R&D in previous years paid off as it saw sales not only rise due to the increase in the size of the cell phone market, but also because of a significant increase in its individual market share. In subsequent years, Motorola rolled out a greater quantity of lower-priced phones, which reduced its ASP, but continued to fuel an increasing market share, especially in more costconscious emerging markets. The high sales volume of lower-priced handsets hurt gross profit margins, but did help sales and profit growth.

In the year 1994, Apple Inc. identified itself in its prospectus as "one of the world 's leading personal computer technology companies." Over time however, the company expanded its product line beyond just personal computers to include other technology products as well. This shift in the company's strategy was evident in Apple's financial statements.

In 2005, the iPod becaroe Apple's best-selling product, accounting for a third of revenues. In 2007, Apple launched the iPhone, and by 2009 the iPhone accounted for 30% of revenues. In 2008, with the launch of the iTunes App Store, Apple became the world 's largest music distributor.

With the introduction of these revolutionary products:

The company's gross margins increased from 33% of sales in 2007 to 40% of sales in 2009. Operating profit margins also improved, but to a lesser extent due to the significant advertising expenses (SG&A) required to support differentiation. Apple was now not only comparable with other computer manufacturers, but also with mobile phone manufacturers and companies developing competing software and systems for mobile internet devices. By the end of 2009 Apple had accumulated nearly $40 billion in the bank (cash and marketable securities). With this "war chest" Apple could undertake large acquisitions or return cash to shareholders in the form of dividends or share repurchases.

LOS 33b: Forecast a company's future net income and cash flow. Vol 3, pp 713-723

Projections of a company's future financial performance are used to determine the value of the company and to evaluate its creditworthiness.

The top-down approach that is typically used to forecast sales involves the following steps:

Attain forecasts for the economy's expected GDP growth rate. Use regression models to determine the historical relationship between the economy's growth rate and the industry's growth rate. Undertake market share analysis to evaluate whether the firm being analyzed is expected to gain, lose, or retain market share over the forecasting horizon.

©2017Wiley


Once a forecast for sales has been established, income and cash flow can be estimated by using the following methods:

Estimate gross or operating profit margins over the forecasting horizon and apply them to revenue forecasts. Net profit margins are affected by leverage ratios and tax rates, so historical data provides a more reliable measure for gross profit margins. This model tends to be simpler and works well for mature companies that operate in nonvolatile markets. Analysts should still examine the underlying data to identify items that are not likely to occur again in the future (e.g. , restructuring charges, sales of business segments and assets, and results of discontinued operations), and remove these transitory items from margin estimates that will be used to make projections.

Make separate forecasts for individual expense items, aggregate them, and subtract the total from sales to calculate net income. This is a very subjective exercise, as each expense item must be projected based on some relationship with sales or another relevant variable. Even more complex models are used for firms with volatile earnings (e.g., oil companies whose earnings have fluctuated significantly with oil prices over the last few years) , and those with no significant performance histories (start-ups in new industries characterized by rapid technological change).

To forecast cash flows, analysts must make assumptions about future sources and uses of cash. An example of a typically employed assumption is that noncash working capital as a percentage of sales remains constant. The most important things that an analyst must consider when forecasting cash flows are:

Required increases in working capital. Capital expenditures on new fixed assets. Repayment and issuance of debt. Repurchase and issuance of stock (equity).

Exhibit 1-1 leads us through a forecasting model that employs fairly straightforward ssumptions.

Exhibit 1-1: Income and Cash Flow Projections

Assumptions First-year sales Annual sales growth COGS as a percentage of sales Operating expenses as a percentage of sales Tax rate Noncash working capital as a percentage of sales Annual investment in fixed capital as a percentage of sales Beginning noncash working capital Beginning cash

©2017Wiley

$100 20% 30% 55% 30% 70% 5% $75 $10


Yrl Yr2 Yr3 Yr4 YrS

Sales (20% rise every year) 100 120 144 172.8 207.4

Cost of goods sold (30% of sales) 30 36 43.2 51.84 62.21

Operating expenses (55% of sales) 55 66 79.2 95.04 114

Pretax income 15 18 21.6 25.92 31.1

Taxes (30% of pretax income) 4.5 5.4 6.48 7.776 9.331

Net income 10.5 12.6 15.12 18.14 21.77 $5 can be disinvested from working capital, as the company started with

~ 12.6

$75 and only requires $70 for the

Net income first year of operations. 15.12 18.14 21.77

Less: Investment in noncash working -5 ~14 16.8 20.16 24.19 capital

Less: Envestment in fixed capital 6 7.2 8.64 10.37

Change in cash 10.5 -7.4 -8.88 -10.66 -12.79

Beginning cash IO 20.5 13.1 422 -6.436

Ending cash $14 must be invested I 20.5 13.1 4.22 -6.436 -19.22 in working capital in I Ye~2. ~

Cash 20.5 13.1 4.22 -6.436 -19.22

Noncash working capital (70% of sales) 70 84 100.8 121 145.2

Current assets 90.5 97.1 105.02 114.5 125.9

In practice, forecasting includes an analysis of the risks inherent in the forecasts. For the example in Exhibit 1-1, the analyst must assess the impact on income and cash flow ifthe actual realized values of certain variables significantly differ from the assumptions used in the model.

LESSON 2: ASSESSING CREDIT RISK AND SCREENING FOR POTENTIAL EQUITY INVESTMENTS

LOS 33c: Describe the role of financial statement analysis in assessing the credit quality of a potential debt investment. Vol 3, pp 723-726

Credit risk is the risk of loss from a counterparty or debtor's failure to make a promised payment.

Credit analysis involves evaluation of the 4 "C's" of a company.

Character refers to the quality of management. Capacity refers to the ability of the issuer to fulfill its obligations. Collateral refers to the assets pledged to secure a loan. Covenants are limitations and restrictions on the activities of issuers.

Financial statements are used to calculate several types of ratios that are used to evaluate the credit risk of a company. The four general categories of items considered are:

© 2017Wiley


Scale and diversification of the business: Larger companies enjoy significant leverage in negotiations with suppliers and lenders. Those with more product lines and a wider geographical reach offer more diversification and have lower credit risk.

Operational efficiency: Firms that earn a higher return on their assets and have better operating and EBITDA margins have lower credit risk.

Stability and sustainability of profit margins: Consistently high profit margins indicate a higher probability of repayment and reflect low credit risk.

Degree of financial leverage: Comfortable levels of cash flow compared to interest payment requirements indicate that a firm is adequately cushioned and should be able to meet debt-servicing requirements comfortably. High ratios of free cash flow to total debt and to interest expense indicate low credit risk.

Example 2-1: Peer Comparison Ratios

Consider the following information regarding two companies operating in the same industry:

Rex Autos Roadways Inc.

EBITDA/Average assets 9.2% 6.7%

Debt/EB ITO A 3.4 4.1

Retained cash flow to debt 15.8% 7.3%

Free cash flow to net debt 8.2% 1.4%

Which company is likely to be given a higher credit rating?

Solution

Based on the given information, Rex Autos is likely to be given a higher credit rating. This is because it has:

A higher level of EBITDA relative to average assets. Lower level of debt relative to EBITDA. Higher retained cash flow relative to debt. Higher free cash flow relative to net debt.

LOS 33d: Describe the use of financial statement analysis in screening for potential equity investments. Vol 3, pp 726-730

Screening is the process of filtering a set of potential investments into a smaller set (that exhibits certain desirable characteristics) by applying a set of criteria. These criteria include financial ratios and other characteristics such as market capitalization and membership of popular indices.

Security selection may be based on top-down analysis or bottom-up analysis.

Top-down analysis involves identifying attractive geographical and industry segments, and then choosing the most attractive investments from them. Bottom-up analysis involves selecting specific investments within a specific investment universe.

© 2017Wiley

BeforecalcuJating these ratios and drawing conclusions, anaJysts should also evaluate the impact of off-balance sheet debt on the company's leverage. This is discussed later in the reading.


Example 2-2 illustrates the use of financial ratios to screen for equity investments.

Example 2-2: Stock Screens

The table below illustrates a simple stock screen:

Stocks Meeting Criterion

Number Percent of Total

PIE< 13 II 22%

Net income/Sales > 0 9 18%

Total debt/ Assets < 0.4 18 36%

Dividend yield> 0.4% 12 24%

Meeting all 4 criteria simultaneously 3 6%

Notice the following: Certain screens serve as checks on other screens.

o The first criterion (PIE< 13) aims to select stocks that are relatively cheaply valued.

o The second (Net income/Sales > 0) and third (Total debt/ Assets < 0.4) criteria serve as checks on the results from applying the first criterion.

The requirement for net income to be positive serves as a check on profitability. Companies with negative earnings would have a negative PIE ratio, and would therefore find their way through the first screen. The limit on financial leverage serves as a check on financial risk.

Criteria are often not independent. This results in more stocks passing the set of screens than if the criteria were independent. In this example:

o If the criteria were completely independent, the number of stocks meeting all 4 criteria would be (0.22 x 0.18 x 0.36 x 0.24) x 50 = 0.17.

o However, the actual number of stocks that meet all 4 criteria is 3. o To understand the lack of independence, note that dividend-paying

capacity (criterion 4) is linked to the ability to generate positive earnings (criterion 2).

Analysts must recognize that the application of certain screens can lead to the results of screens being concentrated within certain sectors. In this example, the criterion 3 (limit on financial leverage) will probably result in banking stocks being excluded from the filtered subset.

© 2017Wiley


Growth investors invest in those companies that are expected to see higher earnings growth in the future. A growth investor would set earnings growth and/or momentum screens like a high price-to-cash flow ratio and sales growth exceeding 20% over the last three years.

Value investors try to pay a low price relative to a company 's net asset value or earning prowess. A value investor might set screens like a higher-than-average return on equity (ROE) and a lower-than-average PIE ratio to shortlist equity investments that suit her style. Use of screens involving financial ratios is most common among value investors.

Market-oriented investors are an intermediate group of investors who cannot be categorized as growth or value investors.

Analysts evaluate how a portfolio based on particular screens would have performed historically through the process of back-testing. This method applies the portfolio selection rules to historical data and calculates returns that would have been realized had particular screens been used. Back-testing has its limitations in that it suffers from various biases (e.g., survivorship bias, look-ahead bias, and data-snooping bias).

When applying a set of screens to filter investements, analysts must also bear in mind that:

Inputs to ratios are derived from financial statements. Companies within the analyst's investment universe may differ with respect to (1) the set of standards they subscribe to (IFRS vs. U.S. GAAP), (2) specific accounting methods permitted within a particular set of standards, or (3) the estimates used in applying a particular accounting method. Back-testing may not provide accurate predictions of future performance. Implementation decisions (e.g., frequency and timing of portfolio re-evaluation that affect taxes and transaction costs) can dramatically influence returns.

LESSON 3: ANALYST ADJUSTMENTS TO REPORTED FINANCIALS

LOS 33e: Explain appropriate analyst adjustments to a company's financial statements to facilitate comparison with another company. Vol 3, pp 730-745

Analysts often need to make adjustments to a company's financial statements to facilitate comparisons with other companies that use different accounting methods or estimate key accounting inputs differently. Some of these adjustments are described below:

Adjustments related to investments: Investments in securities issued by other companies can be classified under different categories. Unrealized gains and losses on securities classified as "financial assets measured at fair value through other comprehensive income" ("available-for-sale" under U.S. GAAP) are not recorded on the income statement. Changes in their values are reflected in other comprehensive income as a part of equity on the balance sheet. Changes in the value of "financial assets measured at fair value through profit or loss" ("trading" under U.S. GAAP) are recorded on the income statement and have an impact on reported profits. If an analyst is comparing two firms with significant differences in classification of investments, adjustments for the different financial statement impact of the two classifications would be necessary.

Adjustments related to inventory: A last in, first out (LIFO) company's financial statements must be adjusted to first in, first out (FIFO) terms before comparisons with FIFO companies can be undertaken. Important accounts affected by conversion from LIFO

©2017Wiley


Before calculating these ratios and drawing conclusions, analysts should also evaluate the impact of off~balance sheet debt on the company's leverage. This is discussed later in the reading.

to FIFO are net income, retained earnings, inventory, cost of goods sold (COGS), and deferred taxes.

U.S. GAAP requires firms that use the LIFO inventory cost flow assumption to disclose the beginning and ending balances for the LIFO reserve in the footnotes to the financial statements. The LIFO reserve equals the difference between the value of inventory under LIFO and its value under FIFO. In periods of rising prices and stable inventory levels, LIFO EI is Lower than FIFO EI. Therefore,

EI FIFO = EI LIFO + LR

where LR = LIFO Reserve

ICOGSFIFo= COGSLIFo -(Change in LR during the year) I

Since COGSFIFo is lower than COGSuFO during periods of rising prices, FIFO gross profits and net income before taxes are greater than their values under LIFO by an amount equal to the change in LIFO reserve. However, net income after tax under FIFO will be greater than LIFO net income after tax by:

I Change in LIFO Reserve x (I - Tax rate) I

The year-end balance of the LIFO reserve represents the cumulative difference in COGS between the FIFO and LIFO cost flow assumptions over the years. Cumulative COGSFIFo will be Jess than cumulative COGSuFO, and consequently, cumulative FIFO gross profits will be higher. However, the entire LIFO reserve will not be added to retained earnings when converting from LIFO to FIFO. The LIFO reserve will be divided between retained earnings (increase in equity) and taxes that have been avoided and delayed by recording lower profits under LIFO (increase in deferred tax liabilities).

When converting from LIFO to FIFO assuming rising prices:

Equity (retained earnings) increase by:

ILIFOReservex (I-Tax rate JI

Liabilities (deferred taxes) increase by:

ILIFO Reserve x (Tax rate) I

Recall the following adjustment to inventory on the balance sheet, which would also make the balance sheet balance:

Current assets (inventory) increase by:

I LIFO Reserve I

© 2017~1ey


Example 3-1: LIFO to FIFO Conversion and Analysis

ABC Company uses the LIFO cost flow assumption to value inventory. An analyst wants to convert ABC's financial statements to FIFO to facilitate comparisons with a FIFO company in the same industry. ABC faces a tax rate of 30%. Inventory levels have been stable and prices have gradually risen over the year.

ABC Company Balance Sheet

Gross fixed assets Accumulated depreciation Net fixed assets Long-term investments

Cash Receivables Inventory Total current assets

Total Assets

Payables Short-term debt Deferred taxes Current portion of long-term debt Current liabilities

Long-term debt

Common stock Retained earnings Common Shareholders' Equity

Total Liabilities and Shareholders' Equity

Notes: LIFO Reserve

©2017Wiley

2009 2008 $ $

3,730 1,910 (1,450) (1,060) 2,280 850 2,500 2,500

410 160 1,900 1,200 1,000 1,950 3,310 3,310

8,090 6,660

250 1,890 130 100 600 1,000 440 210

1,420 3,200

1,760 830

1,500 1,250 3,410 1,380 4,910 2,630

8,090 6,660

270 225


Income Statement

Sales

COGS

Gross profit

Operating expenses

Operating profit

Interest expense

EBT Taxes

Net income

Questions

2009 $

30,650

(26,000)

4,650

(1 ,350)

3,300 (400)

2,900

870

2,030

1. What would ABC's 2009 ending inventory be on a FIFO basis? 2. How much would ABC's COGS for 2009 be on a FIFO basis? 3. What would ABC's net profit be had it used FIFO? 4. What is the cumulative amount of tax savings that ABC has generated by using

LIFO instead of FIFO? 5. What amounts would be added to ABC's deferred tax liabilities and retained

earnings to convert them to FIFO? 6. Comment on how the following ratios would change if FIFO were used in

preparing ABC's account. a. Inventory turnover. b. Number of days of inventory. c. Gross profit margin. d. Current ratio. e. Debt-to-equity ratio.

Solution

1. EIFIFo ; EiuFO + LIFO reserve EIFIFo; $1,000 + $270 ; $1 ,270

2. COGSFIFO ; COGSLIFO - (LR,,nding - LRboginning) COGSFIFO ; $26,000 - ($270 - $225) ; $25,955

3. FIFO net income ; LIFO net income + Change in LIFO reserve x (1 - Tax rate) FIFO net income; $2,030 + [($270 - $225) x (1 - 30%)]; $2,061.50

4. Cumulative amount of tax savings from using LIFO; LIFO reserve x (Tax rate) Cumulative tax savings ; $270 x 30% ; $81

If the company had used FIFO, the additional potential tax liability would amount to $81 , which should be apportioned over several years in the future.

© 2017Wiley


5. The cumulative tax savings calculated in part 4 above would be added to deferred tax liabilities. By using LIFO, the company showed higher COGS and consequently lower profits than it would have reported had it used FIFO.

Retained eamingsFIFo =Retained eamingsuFO +LIFO reserve x (1 -Tax rate) Retained eamingsFIFo = $3,410 + $270 x (I - 0.3) = $3,599

6.a. The inventory turnover ratio would be lower under FIFO because when prices are rising, costs of goods sold is lower and ending inventory higher under FIFO as compared to LIFO.

b. The number of days of inventory would be higher under FIFO because the inventory turnover ratio is lower under FIFO in a period of rising prices.

c. The gross profit margin would be higher under FIFO because COGS is lower. d. The current ratio would be higher under FIFO primarily because ending

inventory is carried at a higher cost under FIFO when prices are rising. e. The debt-to-equity ratio would be lower under FIFO because retained earnings

are higher.

Adjustments related to property, plant, and equipment: A company that uses accelerated depreciation methods and shorter estimated life assumptions for long-lived assets will report lower net income than a firm that employs longer useful life assumptions and uses straight-line depreciation. Depreciation and net fixed asset values must be assessed and necessary adjustments made to bring sets of financial statements on the same footing before making comparisons.

The footnotes to the financial statements provide useful information about a company's long-lived assets and depreciation methods. This information can be used to estimate the average remaining useful life of a company 's assets.

Recall that gross fixed assets (historical cost) minus accumulated depreciation equals net fixed assets (book value).

Gross fixed assets = Accumulated depreciation + Net fixed assets

Below, we divide both sides of this equation by annual depreciation expense and assume straight-line depreciation and zero salvage values for all fixed assets.

Gross investment in fixed assets = Accumulated dq~reciation + Net investment in fixed assets I

Annual depreciation expense Annual depreciation expense Annual depreciation expense

! ! ! Estimated useful or Average age of asset Remaining useful life

depreciable life Annual depreciation expense times The book value of the asset divided

The historical cost of an asset the number of years that the asset by annual depreciation expense divided by its useful life equals has been in use equals equals the number of years the asset

annual depreciation expense under accumulated depreciation. has remaining in its useful life. the straight-line method. Therefore, Therefore, accumulated the historical cost divided by annual depreciation divided by annual

depreciation expense equals the depreciation equals the average estimated useful life. age of the asset.

©2017Wiley


The calculations of estimated useful life, average age, and remaining useful life are important because:

They help identify older, obsolete assets that might make the firm 's operations less efficient. They help forecast future cash flows from investing activities and identify major capital expenditures that the company might need to raise cash for in the future.

In reality, these estimates are difficult to make with great accuracy. Fixed asset disclosures are often quite general, with assets that have different salvage values, depreciation methods, and useful lives often grouped together. However, these estimates are helpful in identifying areas that require further investigation.

Example 3-2: Analysis of Fixed Asset Disclosures

Harton Inc. and Benset Inc. operate in the same industry. An analyst gathers the following information from their fixed asset disclosures.

Harton Inc. (2007) Gross fixed assets ; $500,000 Accumulated depreciation ; $200,000 Depreciation expense; $100,000

Bense! Inc. (2007) Gross fixed assets ; $750,000 Accumulated depreciation ; $600,000 Depreciation expense; $150,000

Calculate the average age, average depreciable life, and remaining useful life of the companies' fixed assets. What conclusions can be drawn from these estimates?

Solution

Average age Average depreciable life Remaining useful life

Harton 200,000/100,000; 2 years 500,000/100,000; 5 years 300,000/100,000; 3 years

Benset 600,000/150,000; 4 years 750,000/150,000; 5 years 150,000/150,000; I year

The age estimates calculated above suggest that Benset's assets are, on average, older than Harton's. We can forecast that Bense! will need to raise cash fairly soon to invest in newer fixed assets. Since both companies operate in the same industry and use the same depreciation method, we would expect the average depreciable lives of their assets to be similar.

Please note:

If the calculated average depreciable life of a company's assets is in line with that of other firms in the industry that use similar equipment, we can conclude that management is not tweaking useful life and salvage value assumptions to manipulate reported profits. Capex divided by the sum of gross PPE and capex can indicate what percentage of the asset base is being renewed through new capital investment. Capex can be compared to asset disposals to gain some insight on growth of the asset base.

© 2017Wiley


Adjustments related to goodwill: Goodwill is recognized when the price paid for the target company in an acquisition exceeds the fair value of the target's net assets. When a company that grows via acquisitions (and recognizes goodwill on acquired companies) is compared to a firm that grows internally, the former will have higher reported assets and a greater book value even if the real economic values of the two companies are identical. Analysts must remove the inflating effect of goodwill on book value and rely on the priceto-tangible book value ratio to make comparisons.

Example 3-3: Ratio Comparisons for Goodwill

The following information relates to two companies, Alpha and Beta:

Alpha Beta ($m) ($m)

Total market capitalization

Shareholders' equity

Goodwill

Other intangible assets

Based on the above information:

70

75

30

55

1. Calculate the P/B ratio for both companies.

llO

120

20

60

2. Calculate the P/B ratio adjusted for goodwill for both companies. 3. Calculate the price/tangible book value ratio for both companies. 4. Given that the industry average P/B multiple is 3.49 and the average price/

tangible book value ratio is 4.23, comment on the ratios for the two companies.

Solution

1. Alpha's P/B ratio; 70n5; 0.93 Beta's P/B ratio; 110/120; 0.92

2. Alpha's P/B ratio adjusted for goodwill; 70/(75 - 30); 1.56 Beta's P/B ratio adjusted for goodwill; 110/(120 - 20); 1.1

3. Alpha's Price/Tangible book value ratio; 70/(75 - 30 - 55); Not meaningful (negative) Beta's Price/Tangible book value ratio; 110/(120 - 20 - 60); 2.75

4. Based on the P/B ratios, both companies appear to be selling at a significant discount to the industry average P/B multiple.

Looking at the P/B ratios adjusted for goodwill, Beta appears to be selling for a lower price relative to book value than Alpha.

Although Beta's price/tangible book value ratio is mathematically higher than that of Alpha, it is still lower than the industry average of 4.23. Alpha has a negative tangible book value, which makes its price/tangible book value ratio meaningless. Based solely on this information, Alpha appears to be relatively expensive compared to Beta.

©2017Wiley

Tangible book value equals book value reduced by all intangible assets (including goodwill).


Adjustments related to off-balance sheet financing: If classified as an operating lease, the lease is treated as a rental contract (with rent expense recorded on the income statement and no asset or liability recognized on the balance sheet). In contrast, if classified as a capital lease, the lessee records the asset and associated liability on its balance sheet. When a lease confers all the risks and benefits of ownership on the lessee but is still accounted for as an operating lease by the lessee, the arrangement gives rise to off-balance sheet financing. As the following example illustrates, off-balance sheet financing arrangements improve reported solvency ratios.

Example 3-4: Analysis of Lease Disclosures

ABC Company has significant future commitments under finance and operating leases. Presented below is selected financial statement information:

Operating Year Capital$ $ 2009 1,500 4,500 2010 1,500 4,000 2011 1,500 4,250

2012 1,500 5,000

2013 1,500 5,250 2014 1,850 4,750

2015 1,850 4,800 2016 1,850 4,800

2017 2,000 3,500

2018 2,000 3,200 Minimum future lease payments 17,050 44,050

Less: Total interest amount 7,116.34 Present value of minimum lease payments 9,933.66

I. Calculate the implicit rate used to calculate present value of minimum lease payments.

2. Why is this implicit rate important in evaluating the company's leases? 3. If operating leases were to be classified as capital leases, what additional

amount would be recognized on the balance sheet under lease obligations? 4. What would be the effect on the debt-to-equity ratio of treating all leases as

finance leases?

Solution

1. The rate implicit in the lease is the discount rate that equates the present value of future lease payments to the given present value ($9,933.66). It is equivalent to the internal rate of return (IRR) of the cash flow stream. In this example, the rate equals 10.5%.

2. The rate implicit in the lease is important because it is used to determine the present value of lease obligations (liability), the value of the leased asset on the balance sheet, interest expense, and the lease amortization schedule. Companies may use higher implicit rates to report lower debt levels. The validity of the rate used by the company can be evaluated by comparing it to the rates used by comparable firms and considering recent market conditions.

S ©2017~1ey


3. If the operating leases were treated as finance leases, the present value of lease payments would be recognized as an asset and a liability. The present value of operating lease obligations equals $26,798 (using the 10.5% implicit rate).

4. Debt levels rise when operating leases are recognized on the balance sheet. Therefore, the debt-to-equity ratio rises (worsens).

Note that another way to estimate the PV of operating lease payments that do not appear on the balance sheet is to assume that the ratio of discounted to undiscounted operating lease payments is the same as the ratio of discounted to undiscounted capital lease payments. In this example, the ratio of discounted to undiscounted capital lease payments is 58.26% (= 9,934/17,050). Therefore, the PV of future operating lease payments can be estimated as 58.26% of 44,050, which equals $25,664.

Aside from the balance sheet adjustments described above, analysts must also perform the following adjustments to the income statement when reclassifying an operating lease as a capital lease:

Rent expense (recognized under an operating lease) must be eliminated. Typically, rent expense when performing this adjustment is estimated as the average of two years of rent expense. Interest expense is added. Interest expense is estimated as the interest rate times the present value of operating lease payments. Depreciation is added. Depreciation is estimated on a straight-line basis for the number of years of future lease payments.

Example 3-5: Effect on Coverage Ratio for Operating Lease Adjustments


Alpha Inc. Beta Inc.

EBIT before adjustment 1,540 1,235

Reported interest expense 210 150

Operating lease payments:

For the year 2010 100 30

For the year 2011 80 20

Present value of lease obligations 440 115

Number of lease payments remaining 8 8

Average interest rate on debt 7% 11%

Based on the given information, calculate the interest coverage ratios for both companies before and after adjusting for operating leases.

©2017Wiley


Solution

Interest coverage ratio = EBIT I Interest expense

Interest coverage ratios before adjusting for the operating leases are calculated as:

Alpha's interest coverage ratio= 1,540 / 210 = 7.33 Beta's interest coverage ratio= 1,235 / 150 = 8.23

Adjusting the income statement to reflect financial performance under a capital lease requires us to assume that the asset acquired under the lease was purchased (with borrowed funds) rather than rented. Under this assumption:

There will be no rent expense (so we will need to add it back to EBIT). Depreciation expense will have to be charged against the asset (so we will need to deduct it from EBIT). Interest expense will have to be charged on the liability (so we will need to add it to reported interest expense).

These adjustments are made in the following table:

EBIT before adjustment

Add back: Rent expense 1

Less: Depreciation expense2

EBIT after adjustment

Interest expense before adjustment

Assumed cost of interest on lease obligation3

Interest expense after adjustment

1Alpha's rent expense= [(100 + 80) /2] = 90 2Alpha's depreciation expense= 440 / 8 = 55

Alpha Inc.

1,540

90

55

1,575

210

30.80

240.80

Beta Inc. 1,235

25

14.38

1,245.63

150

12.65

162.65

3 Alpha's assumed cost of interest on lease obligation= 440 x 7% = 30.80

Interest coverage ratios after adjusting for the operating leases are calculated as:

Alpha's interest coverage ratio= 1,575 / 240.8 = 6.54 Beta's interest coverage ratio= 1,2451162.65 = 7.65

Notice that the interest coverage ratios for both companies have declined. These adjusted coverage ratios reflect the increased obligations associated with the operating leases.

© 2017Wiley

wiley cfa 2017 level i - study guide vol 3

Documents